copyright © 2007 by the mcgraw-hill companies, inc. all rights reserved. adjustments, financial...

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Adjustments,Financial

Statements,and the

Quality of Earnings

Chapter 4

4-2

Business Background

Revenues are recorded

when earned.

Revenues are recorded

when earned.

Expenses are recorded

when incurred.

Expenses are recorded

when incurred.

Because transactions occur over time, ADJUSTMENTS are Because transactions occur over time, ADJUSTMENTS are required at the end of each fiscal period to get the revenues required at the end of each fiscal period to get the revenues

and expenses into the “right” period.and expenses into the “right” period.

Because transactions occur over time, ADJUSTMENTS are Because transactions occur over time, ADJUSTMENTS are required at the end of each fiscal period to get the revenues required at the end of each fiscal period to get the revenues

and expenses into the “right” period.and expenses into the “right” period.

4-3

Accounting Cycle

Prepare financial statements.

Disseminate statements to users.

Prepare financial statements.

Disseminate statements to users.

Close revenues, gains, expenses, and losses to Retained Earnings.

Close revenues, gains, expenses, and losses to Retained Earnings.

During the period: Analyze transactions. Record journal entries. Post amounts to GL Prepare Unadjusted Trial

Balance

During the period: Analyze transactions. Record journal entries. Post amounts to GL Prepare Unadjusted Trial

Balance

At the end of the period: Adjust revenues and

expenses. Prepare Adjusted trial

balance

At the end of the period: Adjust revenues and

expenses. Prepare Adjusted trial

balance

4-4

Unadjusted Trial Balance

A listing of individual accounts, usually in financial or alphabetical order.

Ending debit or credit balances are listed in two separate columns.

Total debit balances should equal total credit balances.

A listing of individual accounts, usually in financial or alphabetical order.

Ending debit or credit balances are listed in two separate columns.

Total debit balances should equal total credit balances.

4-5

Note that total debits = total credits

Note that total debits = total credits

4-6

Accumulated depreciation is a contra-asset account. It is directly related to an asset account but has the opposite balance.

Accumulated depreciation is a contra-asset account. It is directly related to an asset account but has the opposite balance.

4-7

Cost - Accumulated depreciation = Cost - Accumulated depreciation = BOOK VALUE.BOOK VALUE.

Cost - Accumulated depreciation = Cost - Accumulated depreciation = BOOK VALUE.BOOK VALUE.

4-8

The Unadjusted Trial Balance

If total debits do notdo not equal total credits on the trial balance, errors have occurred . . .

in preparing balancedjournal entries,

in preparing balancedjournal entries,

in posting the correct dollareffects of a transaction,

in posting the correct dollareffects of a transaction,

or in copying ending balancesfrom the ledger to the

trial balance.

or in copying ending balancesfrom the ledger to the

trial balance.

4-9

Adjusting Entries

There are two types of adjusting entries.

ACCRUALSACCRUALS

Revenues earned or expenses

incurred that have not been

previously recorded.

Revenues earned or expenses

incurred that have not been

previously recorded.

DEFERRALSDEFERRALS

Receipts of assets or

payments of cash in advance

of revenue or expense

recognition.

Receipts of assets or

payments of cash in advance

of revenue or expense

recognition.

4-10

End of accounting period.

Cash received. Revenues earned.

Example includes rent received in Example includes rent received in advance (an unearned revenue).advance (an unearned revenue).

Example includes rent received in Example includes rent received in advance (an unearned revenue).advance (an unearned revenue).

Deferred Revenue

4-11

Deferred Revenue

On December 1, 2006, Tom’s Rentals received a check for $3,000, for the first four months’ rent from a new tenant.

The entry on December 1, 2006, to record the receipt of the prepaid rent payment would be . . .

On December 1, 2006, Tom’s Rentals received a check for $3,000, for the first four months’ rent from a new tenant.

The entry on December 1, 2006, to record the receipt of the prepaid rent payment would be . . .

This is a LIABILITY accountThis is a LIABILITY account

4-12

Deferred Revenue

We must record the amountWe must record the amountof rent of rent EARNEDEARNED during December. during December.

Since the prepayment is for Since the prepayment is for 4 4 monthsmonths, we can assume that 1/4 of , we can assume that 1/4 of the rent will be earned each month. the rent will be earned each month.

We must record the amountWe must record the amountof rent of rent EARNEDEARNED during December. during December.

Since the prepayment is for Since the prepayment is for 4 4 monthsmonths, we can assume that 1/4 of , we can assume that 1/4 of the rent will be earned each month. the rent will be earned each month.

Received cash for rent

< 4-month prepayment of rent >

12/1/06 12/31/06Year end

2/28/071/31/07 3/31/07

4-13

Deferred Revenue

On December 31, 2006, Tom’s Rentals must adjust the Unearned Rent Revenue account to reflect that one

month of rent revenue has been earned.

$3,000 × 1/4 = $750 per month.

On December 31, 2006, Tom’s Rentals must adjust the Unearned Rent Revenue account to reflect that one

month of rent revenue has been earned.

$3,000 × 1/4 = $750 per month.

In effect, our obligation to let them occupy the space for a period of time has decreased because they used the

space for one month.

In effect, our obligation to let them occupy the space for a period of time has decreased because they used the

space for one month.

4-14

Deferred Revenue

After we post the entry to the T-accounts, the After we post the entry to the T-accounts, the account balances look like this:account balances look like this:

After we post the entry to the T-accounts, the After we post the entry to the T-accounts, the account balances look like this:account balances look like this:

Unearned Rent Revenue

12/31 750 12/1 3000

Bal. 2,250

Rent Revenue

12/31 750

Bal. 750

4-15

Accrued Revenues

When revenues are earned but not yet

recorded at the end of the accounting period

because cash changes hands after the service is

performed or goods delivered

When revenues are earned but not yet

recorded at the end of the accounting period

because cash changes hands after the service is

performed or goods delivered

4-16


Cash receivedRevenues earned

Example includes interest earned during the period (accrued revenue).

Example includes interest earned during the period (accrued revenue).

Accrued Revenue

4-17

Accrued Revenue

On October 1, 2006, Webb, Inc. invests $10,000 for 6 months in a certificate of deposit that pays 6% interest per year. Webb will not receive the interest until the CD matures on March 31, 2007. On December 31, 2006, Webb, Inc. must

make an entry for the interest earned so far.

On October 1, 2006, Webb, Inc. invests $10,000 for 6 months in a certificate of deposit that pays 6% interest per year. Webb will not receive the interest until the CD matures on March 31, 2007. On December 31, 2006, Webb, Inc. must

make an entry for the interest earned so far.

4-18

Accrued Revenue

After we post the entry to the T-accounts, the account balances look like this:


Interest Receivable

12/31 150

Bal. 150

Interest Revenue

12/31 150

Bal. 150

4-19

Chart for Deferred and Accrued Revenues

Deferred Revenue Accrued RevenueCash (+A) Unearned revenue (+L)

Unearned revenue (-L) Revenue receivable (+A) Revenue (+R, + SE) Revenue (+R, +SE)

Cash (+A) Revenue receivable (-A)

During the period

End of the period

Next period

None

NoneCash is received

Cash received before revenue earned

Company has earned revenue

4-20


Cash paid.

Examples include prepaid rent, advertising, Examples include prepaid rent, advertising, and insurance.and insurance.

Examples include prepaid rent, advertising, Examples include prepaid rent, advertising, and insurance.and insurance.

Deferred Expense

Expense incurred.

4-21

Deferred Expense

On January 1, 2006, Matrix, Inc. paid $3,600 for a 3-year fire On January 1, 2006, Matrix, Inc. paid $3,600 for a 3-year fire insurance policy. insurance policy. They are paying in advance for a They are paying in advance for a

resource they will use over a 3-year period.resource they will use over a 3-year period.

The entry on January 1, 2006, to record the policy on The entry on January 1, 2006, to record the policy on Matrix’s books would appear as follows . . .Matrix’s books would appear as follows . . .

On January 1, 2006, Matrix, Inc. paid $3,600 for a 3-year fire On January 1, 2006, Matrix, Inc. paid $3,600 for a 3-year fire insurance policy. insurance policy. They are paying in advance for a They are paying in advance for a

resource they will use over a 3-year period.resource they will use over a 3-year period.

The entry on January 1, 2006, to record the policy on The entry on January 1, 2006, to record the policy on Matrix’s books would appear as follows . . .Matrix’s books would appear as follows . . .

This is an ASSETASSET account

This is an ASSETASSET account

4-22

Deferred Expense

At the end of 2006, we determine how much At the end of 2006, we determine how much of the “prepaid expense” has been used up of the “prepaid expense” has been used up

during the period. during the period. Since the policy is for Since the policy is for 3 years3 years, we can , we can

assume that 1/3 of the policy will expire assume that 1/3 of the policy will expire each year. each year.

At the end of 2006, we determine how much At the end of 2006, we determine how much of the “prepaid expense” has been used up of the “prepaid expense” has been used up

during the period. during the period. Since the policy is for Since the policy is for 3 years3 years, we can , we can

assume that 1/3 of the policy will expire assume that 1/3 of the policy will expire each year. each year.

1/1/06 12/31/06Year end

12/31/07Year end

12/31/07Year end

Paid cash forinsurance

< 3-year insurance policy >

4-23

Deferred Expense

On On December 31, 2006December 31, 2006, Tipton must adjust the Prepaid , Tipton must adjust the Prepaid Insurance Expense account to reflect that 1 year of the Insurance Expense account to reflect that 1 year of the

policy has expired.policy has expired.

$3,600 $3,600 ×× 1/3 = $1,200 per year. 1/3 = $1,200 per year.

On On December 31, 2006December 31, 2006, Tipton must adjust the Prepaid , Tipton must adjust the Prepaid Insurance Expense account to reflect that 1 year of the Insurance Expense account to reflect that 1 year of the

policy has expired.policy has expired.

$3,600 $3,600 ×× 1/3 = $1,200 per year. 1/3 = $1,200 per year.

In effect, the prepaid asset goes down▼▼, while the expense goes up▲▲.

In effect, the prepaid asset goes down▼▼, while the expense goes up▲▲.

4-24

Deferred Expense



PrepaidInsurance Expense

1/1 3,600 12/31 1,200

Bal. 2,400

Insurance Expense

12/31 1,200

Bal. 1,200

Remaining two years of insuranceRemaining two years of insuranceat $1,200 per year.at $1,200 per year.

Remaining two years of insuranceRemaining two years of insuranceat $1,200 per year.at $1,200 per year.

4-25

Accrued Expenses

As of 12/27/06, Denton, Inc. had already paid $1,900,000 in wages for the year. Denton pays its employees every

Friday. Year-end, 12/31/06, falls on a Wednesday. The employees have earned total wages of $50,000 for

Monday through Wednesday of the week ending 1/02/07.

As of 12/27/06, Denton, Inc. had already paid $1,900,000 in wages for the year. Denton pays its employees every

Friday. Year-end, 12/31/06, falls on a Wednesday. The employees have earned total wages of $50,000 for

Monday through Wednesday of the week ending 1/02/07.

4-26

Accrued Expenses



Wages Payable

12/31 50,000

Bal. 50,000

Wages Expense

$1,900,000

Bal. $1,950,000

As of 12/27

12/31 50,000

4-27

Chart for Deferred and Accrued Expenses

Deferred Expense Accrued ExpensePrepaid asset (+A) Cash (-A)

Expense (+E) Expense (+E) Prepaid asset ((-A) Liability (+L)

Liability (-L) Cash (-A)

During the period

End of the period

Next period

None

NoneCash is paid after expense incurred

Cash paid before expense incurred

Company must recognize expense

4-28

Certain circumstances require adjusting entries to record accounting estimates.

Examples include . . . Depreciation Bad debts Income taxes


Examples include . . . Depreciation Bad debts Income taxes $$$

Adjustments Involving Estimates

4-29





Adjustments Involving Estimates

Let’s look at the adjustment for depreciation

expense.

Let’s look at the adjustment for depreciation

expense.

4-30

Depreciation Adjustment

The accounting concept of

depreciation involves the systematic and

rational allocation of the cost of a long-lived asset over

multiple accounting periods it is used to generate revenue.

The accounting concept of

depreciation involves the systematic and

rational allocation of the cost of a long-lived asset over

multiple accounting periods it is used to generate revenue.

This is a “cost allocation” concept,

not a “valuation” concept.

4-31


The journal entry required is to debit Depreciation Expense and to credit an account

called Accumulated Depreciation.

The journal entry required is to debit Depreciation Expense and to credit an account

called Accumulated Depreciation.

This is called a Contra-Asset account.

This is called a Contra-Asset account.

4-32


At January 1, 2004, Papa John’s trial balance showed Accumulated Depreciation of

$149,000 (in thousands of dollars). For the month of January, Papa John’s needs to

recognize $2,500 in depreciation.

At January 1, 2004, Papa John’s trial balance showed Accumulated Depreciation of

$149,000 (in thousands of dollars). For the month of January, Papa John’s needs to

recognize $2,500 in depreciation.

4-33


After we post the entry to the T-accounts, the account balances look like this (in thousands

of dollars):

After we post the entry to the T-accounts, the account balances look like this (in thousands

of dollars):

1/31 2,500

Bal. 151,500

Accumulated Depreciation

Depreciation Expense

1/31 2,500

Bal. 2,500

1/1 149,000

4-34

Closing the Books

Even though the balance sheet

account balances carry forward from

period to period, the income statement accounts do not.

Closing entries:Closing entries:

1.1. Transfer net income (or Transfer net income (or loss) to Retained loss) to Retained Earnings.Earnings.

2.2. Establish a zero balance Establish a zero balance in each of the in each of the temporarytemporary accounts to start the next accounts to start the next accounting period.accounting period.

Closing entries:Closing entries:

1.1. Transfer net income (or Transfer net income (or loss) to Retained loss) to Retained Earnings.Earnings.

2.2. Establish a zero balance Establish a zero balance in each of the in each of the temporarytemporary accounts to start the next accounts to start the next accounting period.accounting period.

4-35

Closing the Books

The following accounts are called temporary temporary or nominal accounts and are

closed at the end of the period . . .

• Revenues.Revenues.• Expenses.Expenses.• Gains.Gains.• Losses.Losses.• Dividends declared.Dividends declared.

• Revenues.Revenues.• Expenses.Expenses.• Gains.Gains.• Losses.Losses.• Dividends declared.Dividends declared.

4-36

Closing the Books

Assets, liabilities, and some stockholders’ Assets, liabilities, and some stockholders’ equity accounts are permanent, or real equity accounts are permanent, or real

accounts, and are accounts, and are nevernever closed. closed.

Assets, liabilities, and some stockholders’ Assets, liabilities, and some stockholders’ equity accounts are permanent, or real equity accounts are permanent, or real

accounts, and are accounts, and are nevernever closed. closed.

Assets.Assets. Liabilities.Liabilities. *Stockholders’ Equity.*Stockholders’ Equity.

Assets.Assets. Liabilities.Liabilities. *Stockholders’ Equity.*Stockholders’ Equity.

4-37

Closing the Books

Two steps are used in the Two steps are used in the closing process . . .closing process . . .

1.1. Close revenues and Close revenues and gains to Retained gains to Retained Earnings.Earnings.

2.2. Close expenses and Close expenses and losses to Retained losses to Retained Earnings.Earnings.

How to

Close

the

Books!

4-38

To close Papa John’s Restaurant Sales Revenue account, the following entry is required:

To close Papa John’s Restaurant Sales Revenue account, the following entry is required:

Closing the Books

4-39

Closing the Books

If we close the other revenue accounts in a

similar fashion, the retained

earnings account looks like this . . .

4-40

To close Papa John’s Cost of Sales - Restaurants account, the following entry is required:

To close Papa John’s Cost of Sales - Restaurants account, the following entry is required:

Closing the Books

4-41

Closing the Books

If we close the other expense accounts in a

similar fashion, the retained

earnings account looks like this . . .

4-42

Closing the Books

Assume that dividends declared are recognized in a separate dividend account, which is

closed to Retained Earnings at the end

of the period.

4-43

Post-Closing Trial Balance

Let’s take a look at the Let’s take a look at the adjustedadjusted trial balance of trial balance of Matrix, Inc. at December 31, 2004. We want to Matrix, Inc. at December 31, 2004. We want to see the difference between the adjusted trial see the difference between the adjusted trial balance and the balance and the post-closingpost-closing trial balance. trial balance.

4-44

Pre-Closing Trial Balance

Close theseClose theseaccounts. Netaccounts. Net

income is $1,200income is $1,200

4-45

Post-Closing Trial Balance

Retained earningsRetained earnings$2,960$2,960

($1,760 + $1,200($1,760 + $1,200net income).net income).

4-46

Judging Earnings Quality

Companies that make relatively pessimistic estimatesthat reduce current income are judged to followconservative financial reporting strategies, andexperienced analysts give these reports more

credence. These companies are viewed as having“higher quality” earnings.

Companies that make relatively pessimistic estimatesthat reduce current income are judged to followconservative financial reporting strategies, andexperienced analysts give these reports more

credence. These companies are viewed as having“higher quality” earnings.

copyright © 2007 by the mcgraw-hill companies, inc. all rights reserved. adjustments, financial...

Documents

adjusted trial balance

unadjusted trial balance

total credit balances

total debit balances

deferred revenue slide

ending balances

opposite balance

liability account slide