1. Chapter 4
Adjustments, Financial Statements, and the Quality of Financial Reporting
Chapter 4: Adjustments, Financial Statements, and the Quality of Financial Reporting

2. Supercuts’ Situation
Supercuts needs to update or adjust their financial information, such as the amount of supplies inventory on hand and interest owed on debt, to ensure the financial statements include the financial results of all the company’s activities for the period.
This chapter continues our discussion of the accounting system, focusing specifically on the adjustments that are needed under accrual basis accounting. We will introduce the closing process. We will also continue to focus on Supercuts.
Supercuts needs to update or adjust their financial information, such as the amount of supplies inventory on hand and interest owed on debt, to ensure the financial statements include the financial results of all the company’s activities for the period.

3. Explain why adjustments are needed.
Learning Objective 1
Explain why adjustments are needed.
Learning objective number 1 is to explain why adjustments are needed.

4. Why Adjustments Are Needed
Accounting systems are designed to record most recurring daily transactions, particularly any involving cash.
The problem is that cash is not always received or paid in the period when the revenue is earned or when the expense is incurred.
Part I
Accounting systems are designed to record most recurring daily transactions, particularly any involving cash.
The problem is that cash is not always received or paid in the period when the revenue is earned or when the expense is incurred.
Part II
The solution for this timing difference is to record adjusting entries at the end of the period to get the amounts reported as revenues and expenses up to date.
Let’s look at an example using Supercuts.
The solution for this timing difference is to record adjusting entries at the end of the period to get the amounts reported as revenues and expenses up to date.

5. Why Adjustments Are Needed
For example, at the end of September, does Supercuts still have $7,200 of Prepaid Rent to use in the future?
No, because Supercuts used 1/3 of the Prepaid Rent in September.
During September, Supercuts incurred Rent Expense of $2,400.
Supercuts needs to adjust or update the balances in both the Prepaid Rent account and the Rent Expense account.
Part I
For example, at the end of September, does Supercuts still have $7,200 of Prepaid Rent to use in the future?
Part II
No, because Supercuts used one-third of the Prepaid Rent in September.
During September, Supercuts incurred Rent Expense of $2,400.
Supercuts needs to adjust or update the balances in both the Prepaid Rent account and the Rent Expense account.
Let’s look at the two types of adjustments.

6. Deferral adjustments are needed when:
Assets
Liabilities
Expenses
Revenues
Deferral adjustments are needed when:
some or all of an asset’s future benefits have expired or been used up in the current period, or
the company provides goods or services in the current period to satisfy an existing liability.
The accounts in a deferral adjustment always go in opposite directions. That is, a decrease in an asset goes with an increase in an expense, and a decrease in a liability goes with an increase in a revenue.
The two types of adjustments are deferral adjustments and accrual adjustments.
Deferral adjustments are needed when some or all of an asset’s future benefits have expired or been used up in the current period, or when the company provides goods or services in the current period to satisfy an existing liability.
Notice that the accounts in a deferral adjustment always go in opposite directions. That is, a decrease in an asset goes with an increase in an expense, and a decrease in a liability goes with an increase in a revenue.

7. Accrual adjustments are needed when:
Assets
Liabilities
Expenses
Revenues
Accrual adjustments are needed when:
assets and revenues are generated in the current period but haven’t been recorded as of the end of the period, or
liabilities and expenses are incurred in the current period but haven’t been recorded as of the end of the period.
The accounts in an accrual adjustment always go in same direction. That is, an increase in an asset goes with an increase in a revenue, and an increase in a liability goes with an increase in an expense.
Accrual adjustments are needed when assets and revenues are generated in the current period but haven’t been recorded as of the end of the period, or when liabilities and expenses are incurred in the current period but haven’t been recorded as of the end of the period.
Notice that the accounts in an accrual adjustment always go in same direction. That is, an increase in an asset goes with an increase in a revenue, and an increase in a liability goes with an increase in an expense.

8. Assets
Liabilities
Expenses
Revenues
The accounts in any adjustment always include one balance sheet account (an asset or liability) and one income statement account (revenue or expense).
The accounts in any adjustment always include one balance sheet account (an asset or liability) and one income statement account (revenue or expense).

9. Prepare adjustments needed at the end of the period.
Learning Objective 2
Prepare adjustments needed at the end of the period.
Learning objective number 2 is to prepare adjustments needed at the end of the period.

10. Making Required Adjustments
The process of making adjusting entries is similar to what you learned in Chapters 2 & 3. The main difference is that adjustments are made at the end of the period immediately prior to preparing financial statements. After determining the necessary adjustments (in Step 1), they are recorded using adjusting journal entries (in Step 2) and then summarized in the accounts (in Step 3). An adjusted trial balance is prepared to ensure total debits still equal total credits after having posted the adjusting journal entries to the accounts. If the accounts are in balance, the financial statements can be prepared and then distributed to interested users.
Let’s see how to use these 3 steps to analyze, record and summarize the required adjustments for Supercuts.

11. Let’s see how to record the necessary adjustment.
Deferral Adjustments
Remember this entry we made in Chapter 2 to record the receipt of hair supplies?
During September, Supercuts used supplies but their use wasn’t recorded simply because it wasn’t efficient to record a journal entry each day when supplies were used.
Let’s see how to record the necessary adjustment.
Part I
Remember this entry we made in Chapter 2 to record the receipt of hair supplies?
Part II
During September, Supercuts used supplies but their use wasn’t recorded simply because it wasn’t efficient to record a journal entry each day when supplies were used.
Let’s see how to record the necessary adjustment.

12. Deferral Adjustments
Step 1 is to analyze the accounts and determine the unadjusted balance for the Supplies account. By looking at the Supplies ledger, we can see that the unadjusted balance in the account is $630. The salon manager counted the supplies on hand and determined you have $400 of supplies left. Since you started with $630 of supplies, that means you used $230 of supplies in September. The desired balance in Supplies is $400 and the desired balance in Supplies Expense (which shows how much we used in supplies this month) is $230.

13. Deferral Adjustments Part I
Step 2 is record the adjusting entry. Take a minute and see if you can prepare the adjusting entry.
Part II
How did you do? The entry is a debit to Supplies Expense and a credit to Supplies for $230.
Let’s see what the accounts look like after we post this adjusting entry.

14. Deferral Adjustments
Step 3 is to post the adjusting journal entry to the T-accounts. Here is what the T-accounts look like after we post this adjusting entry.

15. Deferral Adjustments
Take a minute and look at this Unadjusted Trial Balance. In addition to Supplies, other assets we need to adjust include Prepaid Rent, Prepaid Insurance, and Equipment.
First, let’s look at how to adjust the Prepaid Rent and Prepaid Insurance accounts.
Take a minute and look at this Unadjusted Trial Balance. In addition to Supplies, other assets we need to adjust include Prepaid Rent, Prepaid Insurance, and Equipment.
First, let’s look at how to adjust the Prepaid Rent and Prepaid Insurance accounts.

16. Deferral Adjustments
Recall that the Prepaid Rent of $7,200 was for September, October, and November rent. So, during September, we used 1/3 of the rent, or $2,400.
Part I
Recall that the Prepaid Rent was for September, October, and November rent. So, during September, we used one-third of the rent, or $2,400. Can you prepare the adjusting entry?
Part II
The adjusting entry is a debit to Rent Expense and a credit to Prepaid Rent.
Part III
Here is what the accounts look like after posting this adjusting entry.
After posting this adjusting entry, the ledger accounts would look like this:

17. Deferral Adjustments
Recall that the Prepaid Insurance of $3,600 was for 12 months of insurance. So, during September, we used 1/12 of the insurance, or $300.
Part I
Recall that the Prepaid Insurance was for 12 months of insurance. So, during September, we used one-twelfth of the insurance, or $300. Can you prepare the adjusting entry?
Part II
The adjusting entry is a debit to Insurance Expense and a credit to Prepaid Insurance.
Part III
Here is what the accounts look like after posting this adjusting entry.
After posting this adjusting entry, the ledger accounts would look like this:

18. Deferral adjustments have two effects:
Notice:
They reduce the carrying value of assets on the balance sheet, and
They transfer the amount of the reductions to related expense accounts.
Carrying value simply means the amount an asset or liability is reported at (“carried at”) in the financial statements. It is also known as “net book value” or simply “book value.”
Deferral adjustments have two effects.
First, they reduce the carrying value of assets on the balance sheet. Carrying value simply means the amount an asset or liability is reported at (or “carried at”) in the financial statements. It is also known as “net book value” or simply “book value.”
Second, they transfer the amount of the reductions to related expense accounts.

19. Deferral Adjustments—Depreciation
Recording Depreciation Expense and Accumulated Depreciation
Depreciation is the process of allocating the cost of property and equipment to the accounting periods in which they are used to generate revenues.
Depreciation is a specific type of deferral adjusting entry. The matching principle implies that when buildings and equipment are used to generate revenues in the current period, part of their cost should be transferred to an expense account in that period. Depreciation is the process of allocating the cost of property and equipment to the accounting periods in which they are used to generate revenues.
What is new about this adjusting entry is the use of a contra-account. A contra-account is an account that is an offset to, or reduction of, another account.
Let’s look at an example.
A contra-account is an account that is an offset to, or reduction of, another account.

20. Deferral Adjustments—Depreciation
Your salon manager determined that depreciation on the equipment for this month should be $1,000.
After posting this adjusting entry, the ledger accounts would look like this:
Part I
Your salon manager determined that depreciation on the equipment for this month should be $1,000. Take a minute and prepare the adjusting entry.
Part II
How did you do? The adjusting entry is a debit to Depreciation Expense and a credit to Accumulated Depreciation, the contra-asset account, for $1,000. Accumulated Depreciation is reported in the assets section of the balance sheet and is subtracted from the Equipment account.
Let’s see what the ledger accounts look like after posting this adjusting entry.
Part III
By recording depreciation in Accumulated Depreciation separate from Equipment, it’s possible to report both the original cost of the asset and the amount that has already been depreciated.

21. Deferral Adjustments—Depreciation
Depreciation  Market Value
In accounting, depreciation is never intended to show a reduction in market value.
Don’t misunderstand what depreciation is. Some people mistakenly think that depreciation reflects an asset’s decline in market value. In accounting, depreciation is never intended to show a reduction in market value. Depreciation is used in accounting to match part of an asset’s original cost to the revenues generated in the periods the asset is used.

22. Deferral Adjustments
During September, stylists accepted $175 of gift certificates to pay for haircuts.
After posting this adjusting entry, the ledger accounts would look like this:
Part I
During September, stylists accepted $175 of gift certificates to pay for haircuts. Let’s see the adjusting entry for this.
Part II
The adjusting entry is a debit to Unearned Revenue (to reduce the liability account) and a credit to Haircut Revenue (to increase the revenue earned).
Part III
Here is what the ledger accounts look like after posting this adjusting entry.

23. Let’s see how to record the necessary adjustment.
Accrual Adjustments
On September 30, Supercuts provided $40 of haircut services to the salon manager, with payment to be received in October.
Let’s see how to record the necessary adjustment.
Now, let’s focus on Supercuts’ accrual adjusting entries. On September 30, Supercuts provided $40 of haircut services to the salon manager, with payment to be received in October. Let’s use our three step method to see how to record the necessary adjustment.

24. Accrual Adjustments
Step 1 is to analyze the transaction and see that Supercuts provided $40 of haircut services that have not been recorded. And, the salon manager owes Supercuts $40 for the haircut services received. We will update the adjusted account balances after we record the adjusting journal entry needed.

25. Accrual Adjustments
Step 2 is to record the adjusting journal entry. Can you prepare the adjusting journal entry needed for this transaction?
Part II
The adjusting journal entry is a debit to Accounts Receivable and a credit to Haircut Revenue for $40.

26. Accrual Adjustments
Step 3 is to summarize the effect of the adjusting journal entry in the accounts by posting the transaction to the Accounts Receivable and Haircut Revenue accounts. After posting, both account balances are updated for the effects of this transaction.
Let’s see how the ledger accounts look after posting this adjusting entry.

27. Accrual Adjustments
Supercuts owes $900 of wages to stylists for work done in the last three days of September.
After posting this adjusting entry, the ledger accounts would look like this:
Part I
Supercuts owes $900 of wages to stylists for work done in the last three days of September. Can you prepare the adjusting entry?
Part II
The adjusting entry is debit Wages Expense and credit Wages Payable for $900.
Part III
Here is what the ledger accounts look like after posting this adjusting entry.

28. Accrual Adjustments
Supercuts has not paid or recorded the $100 interest that it owes for this month on its note payable to the bank.
After posting this adjusting entry, the ledger accounts would look like this:
Part I
Supercuts has not paid or recorded the $100 interest that it owes for this month on its note payable to the bank. Can you prepare the adjusting entry?
Part II
The adjusting entry is a debit to Interest Expense and a credit to Interest Payable for $100.
Part III
Here is what the ledger accounts look like after posting this adjusting entry.

29. Accrual Adjustments
Supercuts pays income tax at an average rate equal to 40% of the salon’s income before taxes ($1,685).
After posting this adjusting entry, the ledger accounts would look like this:
Part I
Supercuts pays income tax at an average rate equal to 40% of the salon’s income before taxes ($1,685). Can you prepare the adjusting entry?
Part II
The adjusting entry is debit Income Tax Expense and credit Income Taxes Payable for $674.
Part III
Here is what the ledger accounts look like after posting this adjusting entry.

30. Final Comments Adjusting journal entries never involve cash
Dividends are not expenses of the business.
There are two final comments before we move on. First, review the adjusting journal entries we just prepared for Supercuts. Notice that none of them affected the Cash account. Adjusting journal entries never involve cash.
Second, let’s take a moment and discuss dividends, which are the distribution of profits to stockholders as a return on their investment in the corporation. The decision to pay a dividend is made by the company’s board of directors after profits have been generated, so dividends are not expenses of the business. Instead, they are a reduction of the stockholders’ claim on retained earnings. Consequently, dividends are not reported on the income statement, but instead are subtracted on the statement of retained earnings (as shown in chapter 1).
Let’s look at how to record dividends that Supercuts pays.

31. Supercuts declares and pays a $500 cash dividend.
Dividends
Supercuts declares and pays a $500 cash dividend.
After posting this adjusting entry, the ledger accounts would look like this:
Part I
Supercuts declares and pays $500 cash dividend. Can you prepare the journal entry? Remember that Dividends are not expenses. They are distributions of profits out of Retained Earnings.
Part II
The entry is debit Dividends Declared and credit Cash for $500.
Part III
Here is what the ledger accounts look like after posting this journal entry.

32. Prepare an adjusted trial balance.
Learning Objective 3
Prepare an adjusted trial balance.
Learning objective number 3 is to prepare an adjusted trial balance.

33. The adjusted trial balance is a list of all accounts and their adjusted balances to check on the equality of recorded debits and credits.
Here is the adjusted trial balance for Supercuts. The amounts were taken from the balances in the ledger accounts after adjusting entries were made.
The adjusted trial balance is a list of all accounts and their adjusted balances to check on the equality of recorded debits and credits.
Here is the adjusted trial balance for Supercuts. The amounts were taken from the balances in the ledger accounts after adjusting entries were made.

34. Prepare adjusted financial statements.
Learning Objective 4
Prepare adjusted financial statements.
Learning objective number 4 is to prepare adjusted financial statements.

35. Now let’s prepare the financial statements for Supercuts.
Let’s prepare the financial statements in this order:
Income Statement
Statement of Retained Earnings
Balance Sheet
Now let’s prepare the financial statements in this order: Income Statement, Statement of Retained Earnings, and Balance Sheet.
Take a minute and review these accounts. Which ones would you expect to see on Supercuts’ Income Statement?

36. How did you do? Supercuts has $1,011 in net income for the month of September.
Now, let’s get ready to prepare the Statement of Retained Earnings. Looking at the adjusted trial balance, can you pick out the accounts that would be part of this statement?

37. How does your financial statement compare to this one?
Notice that the Retained Earnings account balance on the adjusted trial balance does not include revenues, expenses and dividends because they have been recorded in their own separate accounts. Eventually we will transfer (or close) these accounts into Retained Earnings, but that’s only done at the end of the year. We will talk more about this process later.
Now, let’s get ready to prepare the Balance Sheet. Review the adjusted trial balance and see if you can find the accounts that will appear on Supercuts’ Balance Sheet?

38. Here is the balance sheet
Here is the balance sheet. Notice that the asset and liability section reported current assets and current liabilities separately from long-term assets and liabilities. When preparing a balance sheet, watch out for two things. First, remember that Accumulated Depreciation is subtracted from Equipment. Second, get the Retained Earnings balance from the Statement of Retained Earnings, not from the adjusted trial balance.
We could also prepare the Statement of Cash Flows, but we will save the details of that financial statement for a later chapter.

39. Explain the closing process.
Learning Objective 5
Explain the closing process.
Learning objective number 5 is to explain the closing process.

40. Closing Temporary Accounts
Establishes zero balances in all income statement and dividend accounts.
At the end of the year, after all transactions and adjustments are recorded, closing journal entries are prepared. Closing entries serve two purposes. First, they transfer net income (or loss) and dividends to Retained Earnings. This process gets the Retained Earnings balance in the ledger up to date. Second, they establish zero balances in all income statement and dividend accounts so they are ready to start collecting amounts for the next accounting period.
Transfers net income (or loss) and dividends to Retained Earnings.

41. Closing Temporary Accounts
Revenues
Expenses
Dividends
Temporary Accounts
Permanent Accounts
Assets
Liabilities
Equity
Permanent accounts track financial results from year to year.
Part I
Accounts that are closed (revenues, expenses, and dividends) are referred to as temporary accounts. Temporary accounts track financial results for a limited period of time.
Part II
Accounts that are not closed (assets, liabilities, and equity) are referred to a permanent accounts. Permanent accounts track financial results from year to year.
Let’s see how to prepare closing journal entries.
Temporary accounts track financial results for a limited period of time.

42. Recording Closing Entries
Debit Revenue accounts and credit Expense accounts. Debit or credit the difference to Retained Earnings.
Credit Dividends Declared and debit Retained Earnings.
Let’s prepare the closing entries for Supercuts!
There are two closing journal entries.
First, debit Revenue accounts and credit Expense accounts. Debit or credit the difference to Retained Earnings.
Second, credit Dividends Declared and debit Retained Earnings.
Let’s prepare the closing entries for Supercuts!

43. Part I
Here is the adjusted trial balance for Supercuts. Can you prepare the closing entry for revenues and expenses?
Part II
Here it is. Compare this entry with the one you did. Are they the same?
Now, prepare the closing journal entry for Dividends Declared.
Part III
Here it is. How did you do?
Now, let’s see how the accounts look after posting these two entries.

44. After posting these closing entries, all the income statement accounts and the dividend account will have a zero balance.
Below is an example of how two accounts would look after posting the closing entries.
After posting these closing entries, all the income statement accounts and the dividend account will have a zero balance.
Here is an example of how two accounts would look after posting the closing entries.

45. Post-Closing Trial Balance
Final check that all debits still equal credits and that all temporary accounts have been closed.
Contains only permanent accounts.
After the closing journal entries are posted, all temporary accounts should have zero balances. These accounts will be ready for recording transactions in the new accounting period. At this point, we prepare a post-closing trial balance as a final check that all debits still equal all credits and that all temporary accounts have been closed.
The post-closing trial balance contains only the permanent accounts because all the temporary accounts have been closed.
Is the last step in the accounting process.

46. Explain how adjustments affect information quality.
Learning Objective 6
Explain how adjustments affect information quality.
Learning objective number 6 is to explain how adjustments affect information quality.

47. Adjustments and Information Quality
If a company bases its adjustments on honest but optimistic estimates that lead to a higher net income, most people will refer to the company as “aggressive” and its earnings as “lower quality”—having been influenced by management’s optimism about the future.
Accounting research studies have found that, overall, adjustments significantly improve the quality of financial statements by ensuring that revenues are recognized when they are earned and expenses are recorded when incurred.
If a company bases its adjustments on honest but optimistic estimates that lead to a higher net income, most people will refer to the company as “aggressive” and its earnings as “lower quality”—having been influenced by management’s optimism about the future.
Accounting research studies have found that, overall, adjustments significantly improve the quality of financial statements by ensuring that revenues are recognized when they are earned and expenses are recorded when incurred.

48. End of Chapter 4
End of chapter 4.