Adjustments, Financial Statements, and the

Quality of Earnings

Chapter 4

McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, Inc.

Understanding the Business
Management is
responsible for
preparing . . .

Financial
Financial Statements
Statements

High Quality . . . Are useful

= Relevance to investors
+ Reliability and creditors.

4-2
Accounting Cycle
Start of Period
During
During the
the period:
period: Close

 Close revenues,
revenues,
 Analyze
 Analyze transactions.
transactions. gains,
gains, expenses,
expenses, and
and
 Record
 Record journal
journal entries.
entries. losses
losses to
to Retained
Retained
 Post
 Post amounts
amounts toto general
general Earnings.
Earnings.
ledger.
ledger.


 Prepare
Prepare financial
financial
At
At the
the end
end of
of the
the period:
period: statements.
statements.
 Adjust
 Adjust revenues
revenues and
and 
 Disseminate
Disseminate
expenses.
expenses. statements
statements to
to
users.
users.

4-3
Purpose of Adjustments
Revenues
Revenues are
are Expenses
Expenses are
are
recorded
recorded when
when recorded
recorded when
when
earned.
earned. incurred.
incurred.

Matching Principle
Because
Because transactions
transactions occur
occur over
over time,
time, ADJUSTMENTS
ADJUSTMENTS are are
required
required at
at the
the end
end of
of each
each fiscal
fiscal period
period toto get
get the
the revenues
revenues
and
and expenses
expenses into
into the
the “right”
“right” period.
period.

4-4
 Types of Adjustments
There are four types of adjustments.

Revenues
Revenues Expenses
Expenses
1.
1. Unearned
Unearned 3.
3. Prepaid
Prepaid
Revenues.
Revenues. Expenses.
Expenses.
2.
2. Accrued
Accrued 4.
4. Accrued
Accrued
Revenues.
Revenues. Expenses.
Expenses.

4-5
Unadjusted Trial Balance


AA listing
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 equal
equal
total
total credit
credit account
account balances.
balances.

4-6
 Note
Note that
that
total
total debits
debits ==
total
total credits
credits

4-7
Accumulated
Accumulateddepreciation
depreciation
isisaacontra-asset
contra-assetaccount.
account.
ItItis
isdirectly
directlyrelated
relatedto
toan
an
asset account but has
asset account but has thethe
opposite
oppositebalance.
balance.

4-8
 Cost
Cost -- Accumulated
Accumulated
depreciation
depreciation == BOOK
BOOK VALUE.
VALUE.

4-9
Unearned Revenues
End of
accounting period.

Cash received. Revenues earned.

Example
Example includes
includes rent
rent received
received in
in
advance
advance (an
(an unearned
unearned revenue).
revenue).

4-10
Unearned Revenues
On
On December
December 1, 1, 2009,
2009, Tom’s
Tom’s Rentals
Rentals received
received aa check
check forfor
$3,000,
$3,000, for
for the
the first
first four
four months’
months’ rent
rent from
from aa new
new tenant.
tenant.
The
The adjustment
adjustment on on December
December 31,31, 2009,
2009, to
to reduce
reduce the
the liability
liability
and
and record
record thethe revenue
revenue earned
earned would
would be:
be:

$3,000 × 1/4 = $750 per month.

4-11
Unearned Revenues

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 Rent Revenue
12/31 750 12/1 3000 12/31 750

Bal. 2,250 Bal. 750

4-12
Accrued Revenue
End of
accounting period.

Revenues earned Cash received

Example
Example includes
includes interest
interest earned
earned
during
during the
the period
period (accrued
(accrued revenue).
revenue).

4-13
Accrued Revenue
At
At December
December 3131stst,, Matrix,
Matrix, Inc.
Inc. earned,
earned, but
but has
has not
not
received,
received, interest
interest on on its
its money
money market
market account
account ofof
$150.
$150. The
The adjustment
adjustment isis mademade toto debit
debit Interest
Interest
Receivable
Receivable and and credit
credit Interest
Interest Revenue.
Revenue.

Interest Receivable Interest Revenue

12/31 150 12/31 150

Bal. 150 Bal. 150

4-14
Prepaid Expenses
End of
accounting period.

Cash paid. Expense incurred.

Examples
Examples include
include prepaid
prepaid rent,
rent,
advertising,
advertising, and
and insurance.
insurance.

4-15
Prepaid Expenses
On
On January
January 1,
1, 2009,
2009, Matrix,
Matrix, Inc.
Inc. paid
paid $3,600
$3,600 for
for aa 3-year
3-year fire
fire
insurance
insurance policy.
policy. They
They are
are paying
paying inin advance
advance for
for aa resource
resource they
they
will
will use
use over
over aa 3-year
3-year period.
period.

At
At December
December 3131stst,, Matrix
Matrix must
must recognize
recognize the
the portion
portion of
of the
the
insurance
insurance that
that has
has beenbeen consumed
consumed and
and becomes
becomes anan expense.
expense.

$3,600 × 1/3 = $1,200 per year.

4-16
Prepaid Expenses
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 Insurance Expense

1/1 3,600 12/31 1,200 12/31 1,200

Bal. 2,400 Bal. 1,200

Remaining two years of insurance

at $1,200 per year.
4-17
Accrued Expenses
End of
accounting period.

Expense incurred. Expense paid.

Examples
Examples include
include accrued
accrued rent,
rent,
accrued
accrued interest,
interest, and
and accrued
accrued wages.
wages.

4-18
Accrued Expenses
As of 12/27/09, Denton, Inc. had already paid $1,900,000 in wages
for the year. Denton pays its employees every Friday. Year-end,
12/31/09, falls on a Wednesday. The employees have earned total
wages of $50,000 for Monday through Wednesday of the week
ending 1/02/10.

4-19
 Accrued Expenses

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 Wages Payable

As of
12/27 $1,900,000 12/31 50,000
12/31 50,000 Bal. 50,000
Bal. $1,950,000

4-20
Accrued Expenses Involving Estimates
Certain circumstances require

adjusting entries to record accounting
estimates.
Examples include . . .

Depreciation
 Depreciation
Bad
 Bad debts
debts
Income
 Income taxes
taxes

4-21
Preparing Financial Statements

The
The next
next step
step in
in the
the accounting
accounting cycle
cycle is
is toto
prepare
prepare the
the financial
financial statements.
statements. .. ..
Income
 Income statement,
statement,

Statement
Statement of
of stockholders’
stockholders’ equity,
equity,
Balance
 Balance sheet,
sheet, and
and
Statement
 Statement of
of cash
cash flows.
flows.

4-22
Financial Statement Relationships

NetThe
income
The incomeincreases
income statement
retained
statement is
iscreated
earnings
created first
first (a
net loss
by
bydetermining
decreases retained
determining the
thedifference
earnings).
difference
Dividends
between
betweendecrease
revenues
revenuesretained
and
andexpenses.
earnings.
expenses.

Decrease RETAINED
DIVIDENDS EARNINGS
Increase

NET
INCOME = REVENUES – EXPENSES

4-23
Financial Statement Relationships

Contributed
Contributed Capital
Capital and
and
Retained STOCKHOLDERS’
Retained Earnings
Earnings make
make
up EQUITY
up Stockholders’
Stockholders’ Equity.
Equity.
Increase

CONTRIBUTED RETAINED
CAPITAL EARNINGS

Increase

NET
INCOME = REVENUES – EXPENSES

4-24
Financial Statement Relationships
STOCKHOLDERS’
ASSETS = LIABILITIES + EQUITY

STOCKHOLDERS’ EQUITY

Increase

CONTRIBUTED RETAINED
CAPITAL EARNINGS
Increase

NET
INCOME = REVENUES – EXPENSES

4-25
 The
The income
income
statement
statement
contains
contains
revenues
revenues and
and
expenses.
expenses.

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

4-26
Statement of Stockholders’ Equity
Net income appears on the statement of stockholders’
equity as an increase in Retained Earnings.

From the
Income
Statement

4-27
Balance Sheet - Assets

$396,000
$396,000 cost
cost ––
$191,500
$191,500
accumulated
accumulated
depreciation
depreciation is
is
equal
equal to
to $204,500.
$204,500.

4-28
Balance Sheet – Liabilities & Stockholders’
Equity

From
From the
the
Statement
Statement of
of
Stockholders’
Stockholders’
Equity.
Equity.

4-29
Focus on Cash Flows

This
This statement
statement isis aa categorized
categorized list
list of
of all
all
transactions
transactions of
of the
the period
period that
that affected
affected the the
Cash
Cash account.
account. The
The three
three categories
categories areare .. .. ..

1.
1. Operating
Operating activities,
activities,
2.
2. Investing
Investing activities,
activities, and
and
3.
3. Financing
Financing activities
activities..

4-30
Focus on Cash Flows

Disclosures
Disclosures
1.
1.Cash
Cash interest
interest paid.
paid.
2.
2.Cash
Cash income
income taxes
taxes paid.
paid.
3.
3.AA schedule
schedule of
of significant
significant noncash
noncash investing
investing and
and
financing
financing transactions..

4-31
Net Profit Margin

Net
Net Profit
Profit Margin
Margin indicates
indicates how
how effective
effective
management
management isis at
at generating
generating profit
profit on
on every
every
dollar
dollar of
of sales.
sales.
Net Profit Net Income
Margin = Net Sales

Net profit margin for Papa John’s for 2006 is:

$63,375,000
= 6.33%
$1,001,557,800

4-32
 Closing the Books

Closing
Closing entries:
entries:
Even though the balance
sheet account balances 1.1. Transfer
Transfernet
netincome
income(or
(orloss)
loss)
carry forward from to
toRetained
RetainedEarnings.
Earnings.
period to period, the 2.2. Establish
Establishaazero
zerobalance
balancein in
income statement each
eachof
ofthe
thetemporary
temporary
accounts do not. accounts
accountstotostart
startthe
thenext
next
accounting
accountingperiod.
period.

4-33
Closing the Books
The following accounts are called temporary
or nominal accounts and are closed at the
end of the period . . .

•• Revenues.
Revenues.
•• Expenses.
Expenses.
•• Gains.
Gains.
•• Losses.
Losses.
•• Dividends
Dividends declared.
declared.

4-34
Closing the Books

Two steps are used in the

closing process . . .
1. Close revenues and gains to
Retained Earnings.
2. Close expenses and losses to
Retained Earnings.

4-35
Closing the Books
To
To close
close Papa
Papa John’s
John’s Restaurant
Restaurant Sales
Sales Revenue
Revenue
account,
account, the
the following
following entry
entry is
is required:
required:

4-36
Closing the Books
To
To close
close Papa
Papa John’s
John’s Cost
Cost of
of Sales
Sales -- Restaurants
Restaurants
account,
account, the
the following
following entry
entry is
is required:
required:

4-37
Closing the Books

Assume we have closed

all other revenue and
expense accounts, and
that dividends declared
are recognized in a
separate dividend
account, which is closed
to Retained Earnings at
the end of the period.

4-38
Post-Closing Trial Balance
After all temporary accounts have been closed, we
prepare a post-closing trial balance. Only assets,
liabilities, and stockholders’ equity accounts will appear.
All revenue, expense, gain and loss accounts will have a
zero balance.

4-39
Accruals and Deferrals: Judging Earnings Quality
Companies that make relatively pessimistic estimates
that reduce current income are judged to follow
conservative financial reporting strategies, and
experienced analysts give these reports more
credence. These companies are viewed as having
“higher quality” earnings.

4-40
 End of Chapter 4

McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, Inc.