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Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Adjustments, Financial Statements, and the Quality of Earnings Chapter 4
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
Management is Management is responsible for responsible for preparing . . .preparing . . .
. . . Are useful . . . Are useful to investors to investors
and creditors.and creditors.
Financial Financial StatementsStatementsFinancial Financial
StatementsStatements
High Quality High Quality = Relevance = Relevance + Reliability+ Reliability
4-3
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.
4-4
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 general
ledger.
During the period: Analyze transactions. Record journal entries. Post amounts to general
ledger.
At the end of the period: Adjust revenues and
expenses.
At the end of the period: Adjust revenues and
expenses.
4-5
Learning Objectives
Explain the purpose of a trial balance.Explain the purpose of a trial balance.
4-6
Unadjusted Trial Balance
A listing of individual accounts, usually in financial statement order.
Ending debit or credit balances are listed in two separate columns.
Total debit account balances should equal total credit account balances.
A listing of individual accounts, usually in financial statement order.
Ending debit or credit balances are listed in two separate columns.
Total debit account balances should equal total credit account balances.
4-7
Note that total debits = total credits
Note that total debits = total credits
4-8
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.
4-9
Cost - Accumulated depreciation = Cost - Accumulated depreciation = BOOK VALUE.BOOK VALUE.
Cost - Accumulated depreciation = Cost - Accumulated depreciation = BOOK VALUE.BOOK VALUE.
4-10
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.
4-11
Learning Objectives
Analyze the adjustments necessary at the end of the period to update balance sheet and
income statement accounts.
Analyze the adjustments necessary at the end of the period to update balance sheet and
income statement accounts.
4-12
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.
4-13
End of accounting period.
Cash receivedor paid.
Revenues earnedor
expense incurred.
Examples include interest earned during the period (accrued revenue) or wages earned by employees but
not yet paid (accrued expense).
Examples include interest earned during the period (accrued revenue) or wages earned by employees but
not yet paid (accrued expense).
Proper Recognition of Revenues and Expenses
4-14
Recognizing Revenues in the Proper Period
When cash is received prior to
earning revenue by delivering goods or
services, the company records a
journal entry to recognize
unearned revenue.
When cash is received prior to
earning revenue by delivering goods or
services, the company records a
journal entry to recognize
unearned revenue.
4-15
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
4-16
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
4-17
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
4-18
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.
4-19
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
4-20
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
4-21
End of accounting period.
Cash receivedRevenues earned
Example includes interest earned during the period (accrued revenue).
Example includes interest earned during the period (accrued revenue).
Accrued Revenue
4-22
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.
4-23
Accrued Revenue
After we post the entry to the T-accounts, the account balances look like this:
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
4-24
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
4-25
Recognizing Expenses in the Proper Period
When cash is paid prior to When cash is paid prior to incurring an expense, the incurring an expense, the
company records a journal company records a journal entry to recognize an asset. entry to recognize an asset. An expense may be incurred An expense may be incurred in the current period but not in the current period but not paid until the next period. paid until the next period.
The company must The company must recognize a liability. recognize a liability.
When cash is paid prior to When cash is paid prior to incurring an expense, the incurring an expense, the
company records a journal company records a journal entry to recognize an asset. entry to recognize an asset. An expense may be incurred An expense may be incurred in the current period but not in the current period but not paid until the next period. paid until the next period.
The company must The company must recognize a liability. recognize a liability.
4-26
End of accounting period.
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.
4-27
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
4-28
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 >
4-29
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▲▲.
4-30
Deferred Expense
After we post the entry to the T-accounts, the account balances look like this:
After we post the entry to the T-accounts, the account balances look like this:
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.
4-31
Accrued Expenses
Recall that accrued expenses Recall that accrued expenses are expenses incurred in the are expenses incurred in the
current period but not billed or current period but not billed or paid until the next accounting paid until the next accounting period. Common examples period. Common examples
are interest expense incurred are interest expense incurred on debt, wages expense owed on debt, wages expense owed
to employees, and utilities to employees, and utilities expense.expense.
Recall that accrued expenses Recall that accrued expenses are expenses incurred in the are expenses incurred in the
current period but not billed or current period but not billed or paid until the next accounting paid until the next accounting period. Common examples period. Common examples
are interest expense incurred are interest expense incurred on debt, wages expense owed on debt, wages expense owed
to employees, and utilities to employees, and utilities expense.expense.
4-32
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.
4-33
Accrued Expenses
After we post the entry to the T-accounts, the account balances look like this:
After we post the entry to the T-accounts, the account balances look like this:
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
4-34
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
4-35
Certain circumstances require adjusting entries to record accounting estimates.
Examples include . . . Depreciation Bad debts Income taxes
Certain circumstances require adjusting entries to record accounting estimates.
Examples include . . . Depreciation Bad debts Income taxes $$$
Adjustments Involving Estimates
4-36
Certain circumstances require adjusting entries to record accounting estimates.
Examples include . . . Depreciation Bad debts Income taxes
Certain circumstances require adjusting entries to record accounting estimates.
Examples include . . . Depreciation Bad debts Income taxes
Adjustments Involving Estimates
Let’s look at the adjustment for depreciation
expense.
Let’s look at the adjustment for depreciation
expense.
4-37
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.
4-38
Depreciation Adjustment
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.
4-39
Depreciation Adjustment
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.
4-40
Depreciation Adjustment
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
4-41
Learning Objectives
Present an income statement with earnings per share, statement of stockholders’ equity, and balance sheet, and supplemental cash flow
information.
Present an income statement with earnings per share, statement of stockholders’ equity, and balance sheet, and supplemental cash flow
information.
4-42
Financial Statement Preparation
The next step in the accounting cycle is to prepare the financial statements. . .
Income statement, Statement of stockholders’ equity, Balance sheet, and Statement of cash flows.
The next step in the accounting cycle is to prepare the financial statements. . .
Income statement, Statement of stockholders’ equity, Balance sheet, and Statement of cash flows.
4-43
The income statement is created first The income statement is created first by determining the difference by determining the difference
between revenues and expenses.between revenues and expenses.
The income statement is created first The income statement is created first by determining the difference by determining the difference
between revenues and expenses.between revenues and expenses.
Net income increases retained earnings (a net loss decreases retained earnings). Dividends decrease retained earnings.
Net income increases retained earnings (a net loss decreases retained earnings). Dividends decrease retained earnings.
Financial Statement Relationships
RETAINED EARNINGS
REVENUES EXPENSES –NET INCOME =
DIVIDENDSDecrease
Increase
4-44
STOCKHOLDERS’ EQUITY
Financial Statement Relationships
CONTRIBUTED CAPITAL
RETAINED EARNINGS
Contributed Capital and Contributed Capital and Retained Earnings make Retained Earnings make up Stockholders’ Equity.up Stockholders’ Equity.
Contributed Capital and Contributed Capital and Retained Earnings make Retained Earnings make up Stockholders’ Equity.up Stockholders’ Equity.
Increase
REVENUES EXPENSES –NET INCOME =
Increase
4-45
Financial Statement Relationships
CONTRIBUTED CAPITAL
RETAINED EARNINGS
ASSETS LIABILITIESSTOCKHOLDERS’
EQUITY = +Increase
REVENUES EXPENSES –NET INCOME =
Increase
4-46
The income statement contains
revenues and expenses.
The income statement contains
revenues and expenses.
Earnings Per Earnings Per Share (EPS) must Share (EPS) must
be reported on be reported on the income the income statement.statement.
Earnings Per Earnings Per Share (EPS) must Share (EPS) must
be reported on be reported on the income the income statement.statement.
4-47
Statement of Stockholders’ Equity
Net income appears on the statement of stockholders’ equity as an increase in Retained Earnings.
From theIncome
Statement
4-48
Balance Sheet - Assets
$362,000 cost – $362,000 cost – $151,500 $151,500
accumulated accumulated depreciation is depreciation is
equal to $210,500.equal to $210,500.
$362,000 cost – $362,000 cost – $151,500 $151,500
accumulated accumulated depreciation is depreciation is
equal to $210,500.equal to $210,500.
4-49
Balance Sheet – Liabilities & Stockholders’ Equity
From the From the statement of statement of
Stockholders’ Stockholders’ Equity.Equity.
From the From the statement of statement of
Stockholders’ Stockholders’ Equity.Equity.
4-50
Statement of Cash Flows
This statement is a categorized list of all This statement is a categorized list of all transactions of the period that affected the transactions of the period that affected the
Cash account. The three categories are . . . Cash account. The three categories are . . .
1.1. Operating activities,Operating activities,
2.2. Investing activities, andInvesting activities, and
3.3. Financing activitiesFinancing activities..
This statement is a categorized list of all This statement is a categorized list of all transactions of the period that affected the transactions of the period that affected the
Cash account. The three categories are . . . Cash account. The three categories are . . .
1.1. Operating activities,Operating activities,
2.2. Investing activities, andInvesting activities, and
3.3. Financing activitiesFinancing activities..
4-51
Statement of Cash Flows
4-52
Learning Objectives
Compute and interpret the net profit margin.Compute and interpret the net profit margin.
4-53
Key Ratio Analysis
Net Profit Margin indicates how effective Net Profit Margin indicates how effective management is at generating profit on every management is at generating profit on every
dollar of sales.dollar of sales.
Net Profit Margin indicates how effective Net Profit Margin indicates how effective management is at generating profit on every management is at generating profit on every
dollar of sales.dollar of sales.
Net IncomeNet Sales
Net ProfitMargin
=
Net profit margin for January 2004 is:Net profit margin for January 2004 is:$7,241,000
$69,800,000= 10.37%10.37%
4-54
Learning Objectives
Explain the closing process.Explain the closing process.
4-55
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.
4-56
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.
4-57
Closing the Books
Assets, liabilities, and stockholders’ equity Assets, liabilities, and stockholders’ equity are permanent, or real accounts, and are are permanent, or real accounts, and are
nevernever closed. closed.
Assets, liabilities, and stockholders’ equity Assets, liabilities, and stockholders’ equity are permanent, or real accounts, and are are permanent, or real accounts, and are
nevernever closed. closed.
Assets.Assets. Liabilities.Liabilities. Stockholders’ Equity.Stockholders’ Equity.
Assets.Assets. Liabilities.Liabilities. Stockholders’ Equity.Stockholders’ Equity.
4-58
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!
4-59
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
4-60
Closing the Books
If we close the other revenue accounts in a
similar fashion, the retained
earnings account looks like this . . .
4-61
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
4-62
Closing the Books
If we close the other expense accounts in a
similar fashion, the retained
earnings account looks like this . . .
4-63
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.
4-64
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.
4-65
Post-Closing Trial Balance
Close theseClose theseaccounts. Netaccounts. Net
income is $1,200income is $1,200
4-66
Post-Closing Trial Balance
Retained earningsRetained earnings$2,960$2,960
($1,760 + $1,200($1,760 + $1,200net income).net income).
4-67
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.
4-68
End of Chapter 4
