Chapter 4

Adjustments, Financial
Statements, and the
Quality of Earnings

4-2

Business Background
Management is
responsible for
preparing . . .

Financial
Financial
Statements
Statements
High Quality
= Relevance
+ Reliability
McGraw-Hill/Irwin

. . . Are useful
to investors
and creditors.

2004 The McGraw-Hill Companie

4-3

Business Background
Revenues
Revenues are
are
recorded
recorded when
when
earned.
earned.

Expenses
Expenses are
are
recorded
recorded when
when
incurred.
incurred.

Because
Becausetransactions
transactionsoccur
occurover
overtime,
time,ADJUSTMENTS
ADJUSTMENTSare
are
required
requiredat
atthe
theend
endof
ofeach
eachfiscal
fiscalperiod
periodto
toget
getthe
therevenues
revenues
and
andexpenses
expensesin
inthe
theright
rightperiod.
period.
McGraw-Hill/Irwin

2004 The McGraw-Hill Companie

4-4

Accounting Cycle
During
Duringthe
theperiod:
period:
Analyze transactions.
Analyze transactions.
Record journal entries.
Record journal entries.
Post amounts to general
Post amounts to general
ledger.
ledger.

At
At the
theend
endof
of the
theperiod:
period:
Adjust revenues and
Adjust revenues and
expenses.
expenses.
McGraw-Hill/Irwin

Close
Closerevenues,
revenues,
gains,
gains,expenses,
expenses,
and
andlosses
lossesto
to
Retained
RetainedEarnings.
Earnings.

Prepare
Preparefinancial
financial
statements.
statements.
Disseminate
Disseminate
statements
statementsto
to
users.
users.

2004 The McGraw-Hill Companie

4-5

The Unadjusted Trial Balance

A
Alisting
listing of
of individual
individual

accounts,
accounts, usually
usually in
in
financial
financial statement
statement order.
order.

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

Total
Total debit
debit account
account balances
balances
should
should == total
total credit
credit account
account
balances.
balances.

McGraw-Hill/Irwin

2004 The McGraw-Hill Companie

4-6

Note
Notethat
that
total
totaldebits
debits==
total
total credits
credits

McGraw-Hill/Irwin

2004 The McGraw-Hill Companie

4-7

The Unadjusted Trial Balance

If total debits do not equal total credits on the
trial balance, errors have occurred . . .
in
in preparing
preparing balanced
balanced
journal
journal entries.
entries.
in
in posting
posting the
the correct
correct dollar
dollar
effects
effects of
of aa transaction.
transaction.
in
in copying
copying ending
ending balances
balances
from
from the
the ledger
ledger to
to the
the
trial
trial balance.
balance.
McGraw-Hill/Irwin

2004 The McGraw-Hill Companie

4-8

Accumulated
Accumulateddepreciation
depreciation
is
is aacontra-asset
contra-asset account.
account.
ItIt is
isdirectly
directlyrelated
related to
to an
an
asset
assetaccount
account but
buthas
hasthe
the
opposite
opposite balance.
balance.
McGraw-Hill/Irwin

2004 The McGraw-Hill Companie

4-9

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

McGraw-Hill/Irwin

2004 The McGraw-Hill Companie

Now that we have

covered the trial
balance, lets
discuss adjusting
entries.

McGraw-Hill/Irwin

4-10

2004 The McGraw-Hill Companie

4-11

Adjusting Entries
There are two types of adjusting entries.
ACCRUALS
ACCRUALS
Revenues
Revenues
earned
earned or
or
expenses
expenses
incurred
incurred but
but no
no
cash
cash has
has been
been
exchanged.
exchanged.

McGraw-Hill/Irwin

DEFERRALS
DEFERRALS
Receipts
Receipts of
of
assets
assets or
or
payments
payments of
of
cash
cash in
in advance
advance
of
of revenue
revenue or
or
expense
expense
recognition.
recognition.

2004 The McGraw-Hill Companie

4-12

Accruals
End of
accounting period.

Revenues earned
or
expense incurred

Cash received
or paid.

Examples
Examplesinclude
includeinterest
interest earned
earnedduring
during the
theperiod
period
(accrued
(accruedrevenue)
revenue)or
or wages
wagesearned
earned by
byemployees
employeesbut
but
not
not yet
yet paid
paid(accrued
(accruedexpense).
expense).
McGraw-Hill/Irwin

2004 The McGraw-Hill Companie

4-13

Accrued revenues
Accrued

revenues: cash is received after

revenues are earned
1 step
Receivable
Revenue

account +

step (after cash is received)

Receivable
Cash

McGraw-Hill/Irwin

account

2004 The McGraw-Hill Companie

4-14

Accrued Revenue - Example 1

On
OnOctober
October1,
1,2003,
2003,Webb,
Webb,Inc.
Inc. invests
invests$10,000
$10,000for
for66
months
monthsin
inaacertificate
certificateof
of deposit
deposit that
that pays
pays6%
6%interest
interest
per
peryear.
year. Webb
Webb will
willnot
not receive
receive the
the interest
interestuntil
untilthe
the
CD
CDmatures
matureson
onMarch
March 31,
31, 2004.
2004. On
On December
December 31,
31, 2003,
2003,
Webb,
Webb,Inc.
Inc.must
mustmake
makean
anentry
entryfor
forthe
theinterest
interest earned
earned
so
sofar.
far.

McGraw-Hill/Irwin

2004 The McGraw-Hill Companie

4-15

Accrued Revenue - Example 1

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

Interest Revenue

12/31 150

12/31 150

Bal.

Bal.

McGraw-Hill/Irwin

150

150

2004 The McGraw-Hill Companie

4-16

Accrued expenses
Accrued

expenses: cash is paid after

expenses are incurred
1 step
Payable

account +
Expense +
2

step (after cash is paid)

Payable
Cash

McGraw-Hill/Irwin

account

2004 The McGraw-Hill Companie

4-17

Accrued Expenses - Example 2

As
Asof
of12/27/03,
12/27/03, Denton,
Denton,Inc.
Inc. had
hadalready
alreadypaid
paid$1,900,000
$1,900,000
in
inwages
wagesfor
forthe
the year.
year. Denton
Denton pays
paysits
itsemployees
employees
every
everyFriday.
Friday. Year-end,
Year-end,12/31/03,
12/31/03,falls
fallson
onaa
Wednesday.
Wednesday.The
Theemployees
employeeshave
haveearned
earnedtotal
totalwages
wages
of
of $50,000
$50,000for
forMonday
Mondaythrough
throughWednesday
Wednesdayof
of the
the
week
week ended
ended1/02/04.
1/02/04.

McGraw-Hill/Irwin

2004 The McGraw-Hill Companie

4-18

Accrued Expenses - Example 2

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

Wages Expense
As of
12/27 $1,900,000
12/31
50,000
Bal.

Wages Payable
12/31 50,000
Bal. 50,000

$1,950,000

McGraw-Hill/Irwin

2004 The McGraw-Hill Companie

4-19

Deferrals
End of
accounting period.

Cash received
or paid.

Revenues earned
or
expense incurred

Examples
Examples include
include rent
rent received
received in
in advance
advance (an
(an
unearned
unearned revenue)
revenue) or
or insurance
insurance paid
paid in
in
advance
advance (a
(a prepaid
prepaid expense).
expense).
McGraw-Hill/Irwin

2004 The McGraw-Hill Companie

4-20

Deferred revenues
Deferred

revenues: cash is received

before revenues are earned
1 step
Unearned
Cash

Revenue (L) +

step (after revenues are earned)

Unearned

revenue (L)
Revenue +
McGraw-Hill/Irwin

2004 The McGraw-Hill Companie

4-21

Unearned Revenue - Example 1

On
OnDecember
December1,
1,2003,
2003, Toms
TomsRentals
Rentals received
receivedaa check
check
for
for$3,000,
$3,000, for
forthe
the first
first four
four months
monthsrent
rent of
of aanew
new
tenant.
tenant.
The
Theentry
entryon
onDecember
December 1,
1,2003,
2003,to
torecord
record the
thereceipt
receiptof
of
the
theprepaid
prepaidrent
rent payment
paymentwould
would be
be.. .. ..

This
This is
isaa LIABILITY
LIABILITY account
account
McGraw-Hill/Irwin

2004 The McGraw-Hill Companie

4-22

Unearned Revenue - Example 2

Received
cash for rent
<
12/1/03

4-month prepayment of rent

12/31/03
Year end

1/31/04

2/28/04

>
3/31/04

We
Wemust
must record
recordthe
theamount
amount
of
ofrent
rent EARNED
EARNEDduring
duringDecember.
December.
Since
Sincethe
theprepayment
prepaymentis
isfor
for 44
months
months,,we
wecan
canassume
assumethat
that 1/4
1/4of
of
the
therent
rentwill
willbe
beearned
earnedeach
eachmonth.
month.
McGraw-Hill/Irwin

2004 The McGraw-Hill Companie

4-23

Unearned Revenue - Example 1

On
On December
December31,
31,2003,
2003,Toms
TomsRentals
Rentalsmust
must adjust
adjust the
the
Unearned
UnearnedRent
RentRevenue
Revenueaccount
accountto
toreflect
reflect that
that11
month
monthof
of rent
rentrevenue
revenuehas
hasbeen
beenearned.
earned.
$3,000
$3,000

1/4
1/4== $750
$750per
permonth.
month.

In
Ineffect,
effect,our
ourobligation
obligationto
tolet
letthem
themoccupy
occupythe
thespace
spacefor
foraa
period
periodof
ofhas
hasdecreased,
decreased,because
becausethey
theyused
usedthe
thespace
spacefor
for11
month.
month.
McGraw-Hill/Irwin

2004 The McGraw-Hill Companie

4-24

Unearned Revenue - Example 1

After
After we
we post
post the
the entry
entry to
to the
the T-accounts,
T-accounts, the
the
account
account balances
balances look
look like
like this:
this:
Unearned Rent
Revenue
12/31 750 12/1 3000
Bal. 2,250

McGraw-Hill/Irwin

Rent Revenue
12/31

750

Bal.

750

2004 The McGraw-Hill Companie

4-25

Deferred expenses
Deferred

expenses: cash is paid before

expenses are incurred
1 step
Pre-paid
Cash

expense (A) +

step (after expenses are incurred)

Pre-paid

expense (A)
Expenses +
McGraw-Hill/Irwin

2004 The McGraw-Hill Companie

4-26

Prepaid Expense - Example 2

On
OnJanuary
January1,
1, 2003,
2003, Tipton,
Tipton, Inc.
Inc. paid
paid$3,600
$3,600for
for aa3-year
3-year
fire
fireinsurance
insurancepolicy.
policy. They
Theyare
arepaying
payingin
inadvance
advancefor
for aa
resource
resourcethey
theywill
willuse
useover
overaa3-year
3-yearperiod.
period.
The
Theentry
entryon
onJanuary
January1,
1,2003,
2003,to
torecord
recordthe
thepolicy
policyon
on
Tiptons
Tiptonsbooks
bookswould
wouldappear
appearas
asfollows
follows ......

This
Thisis
isan
an
ASSET
ASSET account
account
McGraw-Hill/Irwin

2004 The McGraw-Hill Companie

4-27

Prepaid Expense - Example 2

Paid cash for
insurance
<
1/1/03

3-year insurance policy

12/31/03
Year end

12/31/04
Year end

>
12/31/05
Year end

At
Atthe
theend
endof
of2003,
2003,we
wedetermine
determinehow
howmuch
much
of
ofthe
theprepaid
prepaidexpense
expensehas
hasbeen
beenused
usedup
up
during
duringthe
theperiod.
period.
Since
Sincethe
thepolicy
policyis
isfor
for33years
years,,we
wecan
can
assume
assumethat
that1/3
1/3of
ofthe
thepolicy
policywill
willexpire
expire
each
eachyear.
year.
McGraw-Hill/Irwin

2004 The McGraw-Hill Companie

4-28

Prepaid Expense - Example 2

On
OnDecember
December31,
31,2003,
2003,Tipton
Tiptonmust
mustadjust
adjustthe
thePrepaid
Prepaid
Insurance
InsuranceExpense
Expenseaccount
accountto
toreflect
reflectthat
that11year
yearof
ofthe
the
policy
policyhas
hasexpired.
expired.
$3,600
$3,600
1/3
1/3==$1,200
$1,200per
peryear.
year.

In
Ineffect,
effect,the
theprepaid
prepaidasset
assetgoes
goesdown,
down,
while
whilethe
theexpense
expensegoes
goesup.
up.
McGraw-Hill/Irwin

2004 The McGraw-Hill Companie

4-29

Prepaid Expense - Example 2

After
After we
we post
post the
the entry
entry to
to the
the T-accounts,
T-accounts,
the
the account
account balances
balances look
look like
like this:
this:
Prepaid
Insurance Expense
1/1

3,600 12/31 1,200

Bal. 2,400

McGraw-Hill/Irwin

Insurance Expense
12/31 1,200
Bal. 1,200

2004 The McGraw-Hill Companie

4-30

Accounting Estimates

Certain
Certain circumstances
circumstances require
require

adjusting
adjusting entries
entries to
to record
record accounting
accounting
estimates.
estimates.

Examples
Examples include
include .. .. ..

Depreciation
Depreciation

Bad
Bad debts
debts

Income
Income taxes
taxes

$$$
McGraw-Hill/Irwin

2004 The McGraw-Hill Companie

4-31

Accounting Estimates

Certain
Certain circumstances
circumstances require
require

adjusting
adjusting entries
entries to
to record
record accounting
accounting
estimates.
estimates.
Lets
look
at
Lets
look
at

include
.
.
.
Examples
Examples include . . .
how we

Depreciation
Depreciation

Bad
Bad debts
debts

Income
Income taxes
taxes

McGraw-Hill/Irwin

how we
handle
handle
Depreciation
Depreciation
expense.
expense.

2004 The McGraw-Hill Companie

4-32

Depreciation
The
The accounting
accounting
concept
concept of
of
depreciation
depreciation
involves
involves the
the
systematic
systematic and
and
rational
rational allocation
allocation of
of
aa long-lived
long-lived assets
assets
cost
cost to
to the
the multiple
multiple
periods
periods itit is
is used
used to
to
generate
generate revenue.
revenue.
McGraw-Hill/Irwin

This is a cost
allocation concept,
not a valuation
concept.

2004 The McGraw-Hill Companie

4-33

Recording Depreciation
The
The required
required journal
journal entry
entry requires
requires aa debit
debit to
to
Depreciation
Depreciation expense
expense and
and aa credit
credit to
to an
an
account
account called
called Accumulated
Accumulated depreciation.
depreciation.

As
Asdiscussed
discussed earlier,
earlier,this
thisis
is
called
calledaaContra-Asset
Contra-Asset account.
account.
McGraw-Hill/Irwin

2004 The McGraw-Hill Companie

4-34

Depreciation - Example 1
At
AtJanuary
January31,
31,2001,
2001, Papa
PapaJohns
Johnstrial
trialbalance
balanceshowed
showed
Property
Property&&equipment
equipmentof
of$338,000
$338,000(all
(allnumbers
numbersin
in
thousands)
thousands)and
andAccumulated
Accumulateddepreciation
depreciationof
of$83,000.
$83,000.
For
Forthe
theperiod,
period,Papa
PapaJohns
Johnsneeds
needsto
torecord
record an
an
additional
additional$2,500
$2,500in
indepreciation.
depreciation.

McGraw-Hill/Irwin

2004 The McGraw-Hill Companie

4-35

Depreciation - Example 1
After
After we
we post
post the
the entry
entry to
to the
the T-accounts,
T-accounts,
the
the account
account balances
balances look
look like
like this:
this:
Depreciation
Expense
1/31

2,500

Bal.

2,500

Accumulated
Depreciation
1/31 83,000
1/31 2,500
Bal. 85,500

McGraw-Hill/Irwin

2004 The McGraw-Hill Companie

4-36

Financial Statement
Preparation
The
The next
next step
step in
in the
the accounting
accounting cycle
cycle is
is
to
to prepare
prepare the
the financial
financial statements.
statements. .. ..

Income
Income statement,
statement,

Statement
Statement of
of stockholders
stockholdersequity,
equity,

Balance
Balance sheet,
sheet, and
and

Statement
Statement of
of cash
cash flows.
flows.

McGraw-Hill/Irwin

2004 The McGraw-Hill Companie

4-37

Financial Statement
Relationships

Net
income
increases
retained
earnings,
Net
income
increases
retained
earnings,
The
income
statement
is
created
first
The
income
statement
is
created
first
while
aanet
loss
will
decrease
retained
while
net
loss
will
decrease
retained
by
determining
the
difference
by
determining
the
difference
earnings.
Dividends
decrease
retained
earnings.
Dividends
decrease
retained
between
revenues
and
expenses.
between revenues
and expenses.
earnings.
earnings.
RETAINED
EARNINGS

Decrease

DIVIDENDS

Increase

NET
INCOME
McGraw-Hill/Irwin

REVENUES

EXPENSES

2004 The McGraw-Hill Companie

4-38

Financial Statement
Relationships
Contributed Capital and
Contributed Capital and
R/E
R/Emake
makeup
up
Stockholders
StockholdersEquity.
Equity.

STOCKHOLDERS
EQUITY

Increase

CONTRIBUTED
CAPITAL

RETAINED
EARNINGS

Increase

NET
INCOME
McGraw-Hill/Irwin

REVENUES

EXPENSES

2004 The McGraw-Hill Companie

4-39

Financial Statement
Relationships
ASSETS

LIABILITIES

STOCKHOLDERS
EQUITY

Increase

CONTRIBUTED
CAPITAL

RETAINED
EARNINGS

Increase

NET
INCOME
McGraw-Hill/Irwin

REVENUES

EXPENSES

2004 The McGraw-Hill Companie

4-40

Note
Notethat
thatthis
this
statement
statement has
has ONLY
ONLY
revenues
revenues&&
expenses!
expenses!

Earnings
Earnings Per
Per
Share
Share (EPS)
(EPS) must
must
be
be reported
reported on
on
the
the income
income
statement.
statement.

McGraw-Hill/Irwin

2004 The McGraw-Hill Companie

4-41

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

McGraw-Hill/Irwin

2004 The McGraw-Hill Companie

4-42

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

McGraw-Hill/Irwin

2004 The McGraw-Hill Companie

4-43

Balance Sheet - Continued

Remember
Rememberthat
that
Total
Totalliabilities
liabilities
and
andstockholders
stockholders
equity
equity($433,000)
($433,000)
must
mustequal
equalTotal
Total
assets
assets($433,000).
($433,000).

McGraw-Hill/Irwin

2004 The McGraw-Hill Companie

4-44

The Closing Process

Even though the
balance sheet
account balances
carry forward from
period to period, the
income statement
accounts do not.

McGraw-Hill/Irwin

Closing
Closing entries:
entries:
1.
1. Transfer
Transfer net
net income
income (or
(or
loss)
loss) to
to Retained
Retained
Earnings.
Earnings.
2.
2. Establish
Establish aa zero
zero
balance
balance in
in each
each of
of the
the
temporary
temporary accounts
accounts to
to
start
start the
the next
next
accounting
accounting period.
period.

2004 The McGraw-Hill Companie

4-45

The Closing Process

Temporary
Temporaryaccounts
accountsare
areclosed
closedat
atthe
theend
endof
ofthe
theperiod.
period.

Revenues
Revenues

Expenses
Expenses

Gains,
Gains, losses
losses

Dividends
Dividends declared
declared

McGraw-Hill/Irwin

2004 The McGraw-Hill Companie

4-46

The Closing Process

Assets,
Assets, liabilities,
liabilities, and
and stockholders
stockholdersequity
equity are
are
permanent,
permanent, or
or real
real accounts,
accounts, and
and are
are never
never
closed.
closed.

Assets
Assets

Liabilities
Liabilities

Stockholders
Stockholders

Equity
Equity

McGraw-Hill/Irwin

2004 The McGraw-Hill Companie

4-47

The Closing Process

Two steps are used in
the closing process
...
1. Close revenues
and gains to
Retained Earnings.
2. Close expenses
and losses to
Retained Earnings.

McGraw-Hill/Irwin

o
How t
Close
the
!
Books

2004 The McGraw-Hill Companie

4-48

The Closing Process

To
Toclose
closePapa
PapaJohns
JohnsRestaurant
RestaurantSales
SalesRevenue
Revenue
account,
account,the
thefollowing
followingentry
entryis
isrequired:
required:

McGraw-Hill/Irwin

2004 The McGraw-Hill Companie

4-49

The Closing Process

If we close
the other
revenue
accounts in
a similar
fashion,
the
retained
earnings
account
looks like
this . . .
McGraw-Hill/Irwin

2004 The McGraw-Hill Companie

4-50

The Closing Process

To
Toclose
closePapa
PapaJohns
JohnsCost
Costof
ofSales
Sales--Restaurants
Restaurants
account,
account,the
thefollowing
followingentry
entryis
isrequired:
required:

McGraw-Hill/Irwin

2004 The McGraw-Hill Companie

4-51

The Closing Process

If we close
the other
expense
accounts in
a similar
fashion, the
retained
earnings
account
looks like
this . . .
McGraw-Hill/Irwin

2004 The McGraw-Hill Companie

4-52

The Closing Process

Finally, we
close
dividends to
Retained
Earnings and
the account
balances out
to $169,241
and looks like
this . . .
McGraw-Hill/Irwin

2004 The McGraw-Hill Companie

4-53

End of Chapter 4
4

McGraw-Hill/Irwin

2004 The McGraw-Hill Companie