Financial Accounting Chapter 4. Adjustments, Financial Statements, and the Quality of Earnings

Objectives Accounting Cycle Adjustment Closing the Book

Accounting Cycle During the period: l Analyze transactions. l Record journal entries. l Post amounts to general ledger. During the period: l Analyze transactions. l Record journal entries. l Post amounts to general ledger. l Prepare financial statements. l Disseminate statements to users. l Prepare financial statements. l Disseminate statements to users. l Close revenues, gains, expenses, and losses to Retained Earnings. At the end of the period: l Adjust revenues and expenses. At the end of the period: l Adjust revenues and expenses.

Adjustments Trial balance ◦ lists the balances of all accounts. ◦ provides a means of testing whether total debits equal total credits for all accounts. Adjusting entries (or adjustment entries) ◦ are journal entries required at the end of each accounting period to recognize revenues and expenses for the period and to report proper amounts for assets, liabilities, and SHE. ◦ After this, we make financial statements and closing entries are followed.

Four Major Types of Adjustment Entries Expiration of prepaid cost Realization of pre-received revenues Realization of unrecorded expenses Realization of unrecorded revenue

Adjustment Process Step 1 Was revenue earned or an expense incurred that is not yet recorded? Step 2 Was the related cash received or paid in the past or will it be received or paid in the future? Step 3 Compute the amount of revenue earned or expense incurred

1. Expiration of prepaid cost Expiration of prepaid cost = (past) paid in advance and recorded it as an asset (now) then reduce the value of that asset because of the passage of time. = ‘prepaid rent’, ‘prepaid insurance’, ‘depreciation’ and ‘office supply’

2. Realization of pre-received revenues Realization of pre-received revenues = (past) received in advance and recorded it as a liability (now) then reduce the value of that liability because of the passage of time. = ‘unearned revenue’, ‘deferred revenue’ and ‘advance from customers’

3. Realization of unrecorded expenses Realization of unrecorded expenses = (past) no record (now) record them as expenses and create liabilities (accrued payable) (future) record cash outflows and reduce the value of that liability = ‘accrued interest payable’, ‘accrued wages payable’, and ‘accrued income tax payable ’

4. Realization of unrecorded revenue Realization of unrecorded revenue = (past) no record (now) record them as revenues and create non-cash assets (accrued..... receivable) (future) record cash inflows and reduce the value of accrued assets = “accrued fee receivable”

Time Period Assumption Time period (or periodicity) concept is the idea that the life of a business is divided into distinct and relatively short time periods (such as a year or quarter). Fiscal year is an business entity’s reporting year, covering 12 months accounting period)

Closing the book Closing entries are the entries reducing all nominal or temporary accounts to a zero balance at the end of each accounting period, transferring their balances to a permanent balance sheet account (retained earnings). Nominal (temporary) accounts are the accounts that are closed to zero balance at the end of each accounting period (e.g., revenue, expense, and dividend). In contrast, real (permanent) accounts (e.g., assets, liabilities, and SHE) are the accounts that are not closed to a zero balance at the end of period.