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

2. Business Background Financial Statements
Management is responsible for preparing . . .
Financial Statements
High Quality = Relevance + Reliability
. . . Are useful to investors and creditors.

3. Business Background Matching Principle
Revenues are recorded when earned.
Expenses are recorded when incurred.
Matching Principle
Because transactions occur over time, ADJUSTMENTS are required at the end of each fiscal period to get the revenues and expenses in the “right” period.

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

5. The 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 = total credit account balances.

6. Note that total debits = total credits

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

8. Cost - Accumulated depreciation = BOOK VALUE.

9. The Unadjusted Trial Balance
If total debits do not equal total credits on the trial balance, errors have occurred . . .
in preparing balanced
journal entries.
in posting the correct dollar
effects of a transaction.
in copying ending balances
from the ledger to the
trial balance.

10. Now that we have
covered the trial
balance, let’s
discuss adjusting
entries.

11. There are two types of adjusting entries.
ACCRUALS
Revenues earned or expenses incurred that have not been previously recorded.
DEFERRALS
Receipts of assets or payments of cash in advance of revenue or expense recognition.

12. Deferrals End of accounting period. Cash received or paid.
Revenues earned or
expense incurred
Examples include rent received in advance (an unearned revenue) or insurance paid in advance (a prepaid expense).

13. Prepaid Expense - Example 1
On January 1, 2003, Tipton, Inc. paid $3,600 for a 3-year fire insurance policy. They are paying in advance for a resource they will use over a 3-year period. The entry on January 1, 2003, to record the policy on Tipton’s books would appear as follows . . .
This is an ASSET account

14. Prepaid Expense - Example 1
Paid cash for
insurance
< year insurance policy >
1/1/03
12/31/03
Year end
12/31/04
Year end
12/31/05
Year end
At the end of 2003, we determine how much of the “prepaid expense” has been used up during the period.
Since the policy is for 3 years, we can assume that 1/3 of the policy will expire each year.

15. Prepaid Expense - Example 1
On December 31, 2003, Tipton must adjust the Prepaid Insurance Expense account to reflect that 1 year of the policy has expired.
$3,600 × 1/3 = $1,200 per year.
In effect, the prepaid asset goes down, while the expense goes up.

16. Prepaid Expense - Example 1
After we post the entry to the T-accounts, the account balances look like this:
Prepaid
Insurance Expense
1/1 3,600
12/31 1,200
Bal. 2,400
Insurance Expense
12/31 1,200
Bal. 1,200

17. Deferrals
Now, let’s look at an
example of
cash received
in advance.

18. Unearned Revenue - Example 2
On December 1, 2003, Tom’s Rentals received a check for $3,000, for the first four months’ rent of a new tenant.
The entry on December 1, 2003, to record the receipt of the prepaid rent payment would be . . .
This is a LIABILITY account

19. Unearned Revenue - Example 2
Received cash for rent
< month prepayment of rent >
12/1/03
12/31/03
Year end
1/31/04
2/28/04
3/31/04
We must record the amount
of rent EARNED during December.
Since the prepayment is for 4 months, we can assume that 1/4 of the rent will be earned each month.

20. Unearned Revenue - Example 2
On December 31, 2003, Tom’s Rentals must adjust the Unearned Rent Revenue account to reflect that 1 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 has decreased, because they used the space for 1 month.

21. Unearned Revenue - Example 2
After we post the entry to the T-accounts, the account balances look like this:
Unearned Rent Revenue
12/
12/
Bal. 2,250
Rent Revenue
12/
Bal

22. Now, we need to look at adjusting entries for accruals.

23. Accruals
Accruals occur when revenues have been earned or expenses incurred but no cash has been exchanged.

24. Accruals End of accounting period. Revenues earned or expense incurred
Cash received
or paid.
Examples include interest earned during the period (accrued revenue) or wages earned by employees but not yet paid (accrued expense).

25. Accrued Revenue - Example 1
On October 1, 2003, 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, On December 31, 2003, Webb, Inc. must make an entry for the interest earned so far.

26. Accrued Revenue - Example 1
After we post the entry to the T-accounts, the account balances look like this:
Interest Receivable
12/
Bal
Interest Revenue
12/
Bal

27. Accrued Expenses - Example 2
As of 12/27/03, Denton, Inc. had already paid $1,900,000 in wages for the year. Denton pays its employees every Friday. Year-end, 12/31/03, falls on a Wednesday. The employees have earned total wages of $50,000 for Monday through Wednesday of the week ended 1/02/04.

28. Accrued Expenses - Example 2
After we post the entry to the T-accounts, the account balances look like this:
Wages Expense
$1,900,000
Bal. $1,950,000
As of 12/27
12/ ,000
Wages Payable
12/31 50,000
Bal. 50,000

29. Accounting Estimates $$$
Certain circumstances require adjusting entries to record accounting estimates.
Examples include . . .
Depreciation
Bad debts
Income taxes
$$$

30. Let’s look at how we handle Depreciation expense.
Accounting Estimates
Certain circumstances require adjusting entries to record accounting estimates.
Examples include . . .
Depreciation
Bad debts
Income taxes
Let’s look at how we handle Depreciation expense.

31. This is a “cost allocation” concept, not a “valuation” concept.
Depreciation
The accounting concept of depreciation involves the systematic and rational allocation of a long-lived asset’s cost to the multiple periods it is used to generate revenue.
This is a “cost allocation” concept, not a “valuation” concept.
Market
Value

32. Recording Depreciation
The required journal entry requires a debit to Depreciation expense and a credit to an account called Accumulated depreciation.
As discussed earlier, this is called a Contra-Asset account.

33. Depreciation - Example 1
At January 31, 2001, Papa John’s trial balance showed Property & equipment of $338,000 (all numbers in thousands) and Accumulated depreciation of $83,000. For the period, Papa John’s needs to record an additional $2,500 in depreciation.

34. Depreciation - Example 1
After we post the entry to the T-accounts, the account balances look like this:
Depreciation Expense
1/ ,500
Bal ,500
Accumulated Depreciation
1/ ,000
1/ ,500
Bal. 85,500

35. 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.

36. Financial Statement Relationships
Net income increases retained earnings, while a net loss will decrease retained earnings. Dividends decrease retained earnings.
The income statement is created first by determining the difference between revenues and expenses.
RETAINED EARNINGS
Decrease
DIVIDENDS
Increase
REVENUES
EXPENSES –
NET INCOME =

37. Financial Statement Relationships
Contributed Capital and R/E make up Stockholders’ Equity.
STOCKHOLDERS’ EQUITY
Increase
CONTRIBUTED CAPITAL
RETAINED EARNINGS
Increase
REVENUES
EXPENSES –
NET INCOME =

38. Financial Statement Relationships
ASSETS
LIABILITIES
STOCKHOLDERS’ EQUITY = +
Increase
CONTRIBUTED CAPITAL
RETAINED EARNINGS
Increase
REVENUES
EXPENSES –
NET INCOME =

39. Earnings Per Share (EPS) must be reported on the income statement.
Note that this statement has ONLY revenues & expenses!
Earnings Per Share (EPS) must be reported on the income statement.

40. Statement of Stockholders’ Equity
Net income appears on the statement of stockholders’ equity as an increase in Retained Earnings.

41. $338,000 cost – $85,500 accumulated depreciation and amortization.
Balance Sheet
$338,000 cost – $85,500 accumulated depreciation and amortization.

42. Balance Sheet - Continued
Remember that Total liabilities and stockholders’ equity ($433,000) must equal Total assets ($433,000).

43. Statement of Cash Flows
This statement is a categorized list of all transactions of the period that affected the Cash account. The three categories are . . .
Operating activities,
Investing activities, and
Financing activities.

44. Statement of Cash Flows - General Model

45. Key Ratio Analysis: Net Profit Margin
Net Profit Margin gives an indication of how effective management is at generating profit on every dollar of sales.

46. Key Ratio Analysis: Net Profit Margin
The 2000 net profit margin for Papa John’s is based on net income of $32,000,000 and on sales of $945,000,000, giving them a net profit margin of 3.39%.

47. The Closing Process
Even though the balance sheet account balances carry forward from period to period, the income statement accounts do not.
Closing entries:
Transfer net income (or loss) to Retained Earnings.
Establish a zero balance in each of the temporary accounts to start the next accounting period.

48. The Closing Process
The following accounts are called temporary or nominal accounts and are closed at the end of the period . . .
Revenues
Expenses
Gains,
Losses, and
Dividends declared.

49. The Closing Process Assets Liabilities Stockholders’ Equity
Assets, liabilities, and stockholders’ equity are permanent, or real accounts, and are never closed.
Assets
Liabilities
Stockholders’ Equity

50. Two steps are used in the closing process . . .
Close revenues and gains to Retained Earnings.
Close expenses and losses to Retained Earnings.
How to
Close
the
Books!

51. The Closing Process
To close Papa John’s Restaurant Sales Revenue account, the following entry is required:

52. The Closing Process
If we close the other revenue accounts in a similar fashion, the retained earnings account looks like this . . .

53. The Closing Process
To close Papa John’s Cost of Sales - Restaurants account, the following entry is required:

54. The Closing Process
If we close the other expense accounts in a similar fashion, the retained earnings account looks like this . . .

55. The Closing Process
Finally, we close dividends to Retained Earnings and the account balances out to $169,241 and looks like this . . .

56. End of Chapter 4 4