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  • Chapter 4: Adjustments, financial statements, and the quality of earnings. Managers of most companies understand the need to present financial information fairly so as not to mislead users. However, since end-of-period adjustments are the most complex portion of the annual recordkeeping process, they are prone to error. External auditors examine the company’s records on a test, or sample, basis. To maximize the chance of detecting any errors significant enough to affect users’ decisions, CPAs allocate more of their testing to transactions most likely to be in error.
  • Management bears the ultimate responsibility for the preparation of financial statements. High quality financial statements are those that are considered relevant and reliable to the user.
  • Here is another look at the accounting cycle that we previewed in the last chapter. In this chapter, we will devote a significant amount of time learning about adjusting entries.
  • The trial balance is a listing of all of the account balances in our general ledger. The total of all debit balance accounts should equal the total of all credit balance accounts. When this occurs we can say that the books are in balance.
  • Here is part of the unadjusted trial balance of Papa John’s for at the end of January 2009. We have shown all the accounts through stockholders’ equity. We have indicated possible adjustments that may be required depending upon the facts. We usually report property, plant, and equipment net of accumulated depreciation. The reported amount is called net book value. Accumulated depreciation accounts are called “contra” asset accounts. Contra accounts reduce the account to which they are related. In our case, Property and Equipment are reduced by Accumulated Depreciation to arrive at Net Book Value. The remainder of the trial balance appears on the next slide.
  • This is the remainder of the unadjusted trial balance of Papa John’s. This part of the trial balance covers revenues and gains as well as expenses and losses. As on the previous screen we have indicated possible adjusting entries that may be required depending upon the facts. Notice that the total debits equal the total credits, so the accounting equation is in balance. If the total debits did not equal the total credits, one or more errors have been made in the accounting process.
  • As we have learned in previous chapters, the matching principle requires that revenue be recorded when earned and expenses be recorded when incurred. But some transactions begin in one accounting period and are not completed until following accounting period. So at the end of each accounting period we need to make proper adjustments to ensure that all the revenue has been recognized and all the expenses are recorded in the proper accounting period.
  • There are four types of adjustments. Two types of adjustments increase Revenue and two types of adjustments increase Expenses. The first two types of adjusting entries increase revenues. Deferred revenues represent previously recorded liabilities that were created when cash was received in advance, and that must be adjusted for the amount of revenue actually earned during the period. Accrued revenues represent revenues that were earned but not recorded because cash was received after the services were performed or goods were delivered. The next two types of adjustments increase expenses. Deferred expenses represent previously recorded assets, such as prepaid rent, supplies, and equipment, that must be adjusted for the amount of expense actually incurred during the period through use of the asset. Accrued expenses represent expenses that were incurred but were not recorded because cash was paid after the goods or services were received.
  • This is a very important screen when you are preparing your homework solutions. Let’s look at the top left box which deals with adjustments that recognize revenue. When you determine that revenue has been earned and the original journal entry was to increase cash and to recognize a liability called “unearned revenue,” the correct adjusting entry is to debit unearned revenue and credit revenue for the amount of revenue earned. If revenue has been earned due to the passage of time or another reason, and is not recorded, the correct adjusting journal entry is to debit the receivable account (for example, interest receivable), and credit the revenue account. These are the only proper adjusting entries when revenue has been earned. There are only two proper adjusting entries for the recognition of expenses. The first is when we have previously recognized a prepaid expense like rent, insurance, or others, and time has past. We need to recognized the expense in the current accounting period through an entry to debit the expense account and credit the prepaid expense. When we have an accrued expense, we have not recorded the expense in the current accounting period. The proper adjusting entry is to debit the expense account and credit the payable account.
  • Papa John’s received cash last period and recorded an increase in Cash and increase in Unearned Franchise Fees, a liability, to recognize the business’s obligation to provide future services to franchisees. During January, Papa John’s performed $1,100 in services for franchisees who had previously paid fees. At the end of the accounting period, it’s necessary to make an adjusting entry to recognize the revenue earned as a result of providing services to the franchisees. You may remember from the previous screen that the proper adjusting journal entry is to debit the Unearned Franchise Fee for $1,100, and credit the Franchise Fee Revenue for the same amount.
  • Papa John’s franchisees owe Papa John’s $830 in royalties for sales the franchisees made in the last week of January. The cash will be received in the future. At the end of the accounting period, it’s necessary to make an adjusting entry to recognize the revenue earned. The proper adjusting journal entry is to debit the Accounts Receivable for $830, and credit the Franchise Fee Revenue for the same amount.
  • Papa John’s loaned $3,000 to franchisees on December 31 (one month ago) at 6 percent interest per year with interest to be paid at the end of each year. There was also $8,000 in notes receivable outstanding all month from prior loans. There are two components when lending or borrowing money: principal (the amount loaned or borrowed) and interest (the cost of borrowing). Notes Receivable (the principal) was recorded properly when the money was loaned. As shown on the screen, the total interest earned by Papa John’s is $70. This amount has not be recorded because it will not be paid until the end of the year.
  • Papa John’s loaned $3,000 to franchisees on December 31 (one month ago) at 6 percent interest per year with interest to be paid at the end of each year. There was also $8,000 in notes receivable outstanding all month from prior loans. There are two components when lending or borrowing money: principal (the amount loaned or borrowed) and interest (the cost of borrowing). Notes Receivable (the principal) was recorded properly when the money was loaned. As shown on the screen, the total interest earned by Papa John’s is $70. This amount has not be recorded because it is not to be paid until the end of the year.
  • Prepaid Expenses includes $2,000 paid on January 1 for insurance coverage for four months (January through April) and $6,000 paid on January 1 for rental of space at shopping centers over three months (January through March). Here we show the computation of the expense that will be recognized in January.
  • Prepaid Expenses includes $2,000 paid on January 1 for insurance coverage for four months (January through April) and $6,000 paid on January 1 for rental of space at shopping centers over three months (January through March). The adjusted journal entry required is to debit Interest Expense for $500, debit Rent Expense for $2,000, and credit Prepaid Expenses for $2,500.
  • Supplies include food and paper products. At the end of the month, Papa John’s counted $12,000 in supplies on hand, but the Supplies account indicated a balance of $16,000. We need to determine the supplies used during the current accounting period. The computation of the amount of supplies used is shown in the box on this screen and is $4,000.
  • Once we determine that the supplies used during the period amounted to $4,000, we must prepare and adjusting journal entry to debit Supplies Expense for $4,000, and credit the asset account, Supplies, for the same amount. With this entry we include the supplies used this period in the current period income statement.
  • Property and equipment are assets that have a normal debit balance. Depreciation is the allocation of the cost of an asset over its estimated useful life to the company. Depreciation is an expense with a normal debit balance. When we record depreciation we credit a “contra asset account” called Accumulated Depreciation. Contra-accounts are accounts that are directly linked to another account, but with an opposite balance. We subtract accumulated depreciation from the cost of our property and equipment to arrive at net book value.
  • Papa John’s estimates depreciation to be $30,000 per year. We must estimate depreciation for one month so we divide the total $30,000 by 12 months to arrive at an adjustment of $2,500. The proper adjusting journal entry is to debit depreciation expense for $2,500, and credit, the contra account, accumulated depreciation for the same amount. 4-
  • Papa John’s owed (1) its employees salaries for working four days at the end of January at $500 per day, (2) $610 for utilities used in January, and (3) interest on its long-term notes payable borrowed at a 6 percent annual rate. We owe $610 for utilities and must calculate the total salaries owed and the total interest expense incurred. In the second box on the page you can see the calculation of the salaries expense of $2,000, and the calculation of interest expense of $690. Now, we must prepare the necessary adjusting journal entry.
  • Our adjusting journal entry is to debit Salaries Expense for $2,000; debit Utilities Expense for $610, debit Interest Expense for $690, and credit Accrued Expenses Payable, a liability, for the total of $3,300. Let’s move on to our next, and final adjusting entry for this period.
  • The final adjusting journal entry is to record the accrual of income taxes that will be paid in the next quarter. This requires computing adjusted pretax income (that is, balances from the unadjusted trial balance plus the effects of all of the other adjustments). We show the unadjusted total revenues and gains along with the unadjusted expenses and losses. Next, we adjust these amounts for the revenues and expenses recorded in our adjusting entries. The difference between are adjusted revenue and gains and adjusted expenses and losses will be treated as pretax financial income in our example.
  • The journal entry to accrue income taxes for the month is a debit, or increase, to Income Tax Expense for $3,910, and a credit, or increase in the liability account, Income Tax Payable for the same amount.
  • There are a small minority of managers who are willing to use adjustments and deferrals to manipulate income for the period. For example, if the company records too little depreciation, net income will be higher than normal. Depreciation is an estimate and not a precise measurement and it may be difficult to determine the motivation of a manager trying to manipulate net income. What do you think of this situation? Is there any way to prevent or minimize the practice?
  • Before we prepare a complete set of financial statements, let’s update the trial balance to reflect the adjustments and provide us with adjusted balances for the statements. Most companies use the Statement of Stockholders’ Equity rather than the Statement of Retained Earnings. The Statement of Stockholders’ Equity explains the changes in Retained Earnings as well as changes in other Stockholders’ Equity accounts. Once we complete the adjusted trial balance we can begin the process of preparing the financial statements. We know that we begin the process of preparing the financial statements with the income statement.
  • We have posted our eight adjusting journal entries in the two yellow columns. To the right of the adjustments, are the adjusted trial balance amounts that will be used to prepare the financial statements. Notice that the total debits and credits are equal in all six columns shown.
  • Remember that the financial statements are related. Net income flows into Retained Earnings. Retained earnings is combined with contributed capital to form stockholders’ equity. Stockholders’ Equity is an integral part of the balance sheet.
  • This is the income statement drawn from the adjusted trial balance. Refer back to the adjusted trial balance and trace the income statement numbers forward. Notice that gains and losses are reported in the Other Items section of the statement. Operating income, a significant measure of performance, was $8,120,000 for the month ended January 31, 2009. Earning per share are 27 cents for the month and we will discuss the computation of this amount in more detail on the following screen.
  • EPS is the only ratio required to be disclosed on the statement or in the notes to the statements. The actual computation of the ratio is quite complex and appropriate for more advanced accounting courses. For this course, the denominator is the average number of shares outstanding (number at the beginning of the period plus the number at the end of the period, divided by two) divided into net income.
  • Here is Papa John’s statement of stockholders’ equity for the month ended January 31, 2009. You can see that net income increases retained earnings and dividends decrease retained earnings. The balance in the retained earnings account is $136,590 will appear on the balance sheet of the company.
  • Here is the balance sheet of Papa John’s for the month ended January 31, 2009. Notice how the retained earnings flowed through to the balance sheet. Without the proper balance in Retained Earnings, the balance sheet would not balance. Accumulated Depreciation, has been subtracted from the Property and Equipment account to reflect net book value (or carrying value) at month-end for balance sheet purposes. Assets are listed in order of liquidity, and liabilities are listed in order of due dates. Current assets are those used or turned into cash within one year (as well as inventory). Current liabilities are obligations to be paid with current assets within one year.
  • As we have seen before, the statement of cash flows is divided into three major sections, (1) operating activities, (2) investing activities, and (3) financing activities.
  • For complete disclosure, companies are required to provide supplemental information on the statement itself or in the notes to the financial statements. These disclosures must include: Cash interest paid during the period. Cash taxes paid during the period. A supplemental schedule showing significant noncash investing and financing transactions. For example, if the company issued common stock to purchase a building, the transaction would not involve cash, but must be disclosed because it involves both a financing and investing activity.
  • Net profit margin is determined by dividing net income by net sales. The net profit margin is an excellent indicator of how effective management is in earning profits from every dollars worth of sales. For the 2008, Papa John’s net profit margin was 3.25%. Papa John’s net profit margin decreased significantly between 2007 and 2008. The company explained that the decrease in profit margin was due largely to increased labor costs due to the federal minimum wage and increased cost of cheese.
  • All balance sheet accounts (referred to as permanent or real accounts) are carried forward from one period to the next. For example, the ending Cash balance of the prior accounting period is the beginning Cash balance of the next accounting period. On the other hand, revenue, expense, gain, and loss accounts are used to accumulate data for the current accounting period only; they are called temporary or nominal accounts. At the end of each period, the balances in the temporary (income statement) accounts are transferred, or closed, to the Retained Earnings account by recording a closing entry. A closing entry has two purposes: transfers balances in temporary accounts to Retained Earnings and establishes zero balances in temporary accounts.    
  • We created a short example with one revenue, one gain, one expense, and one loss to illustrate the closing entry. Sales revenue was a normal credit balance, so to close the account to zero, we debit Sales Revenue for $100. Expenses have a normal debit balance, so to close the account to zero, we credit Wages Expenses for $40. After all revenues, gains, expenses, and losses are closed we have transferred net income of $80 to Retained Earnings. In addition, all temporary accounts have a zero balance. We have accomplished the two purposes of the closing process. On the next screen we make the closing journal entry for Papa John’s for the month of January.
  • Please spend some time reviewing the closing entry for Papa John’s. Notice that all revenues and gains which have a normal credit balance are debited in the closing process. All expenses and losses have a normal debit balance and we credit these accounts in the closing process. We transfer net income of $7,590 to Retained Earnings. Finally, notice that we do not close any real accounts; assets, liability, or stockholders’ equity accounts. We never close these accounts.
  • 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.
  • End of chapter 4. 1-
  • Transcript

    • 1. Adjustments, Financial Statements, and the Quality of Earnings Chapter 04 Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin
    • 2. Understanding the Business Management is responsible for preparing . . . . . . useful to investors and creditors. High Quality = Relevance + Reliab ility Financial Statements
    • 3. Accounting Cycle
      • During the period:
      • Analyze transactions.
      • Record journal entries.
      • Post amounts to general ledger.
      • Prepare financial statements.
      • Disseminate statements to users.
      • Close revenues, gains, expenses, and losses to Retained Earnings.
      Start of Period
      • At the end of the period:
      • Adjust revenues and expenses.
    • 4. 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 equal total credit account balances.
    • 5. Partial Trial Balance
    • 6. Partial Trial Balance
    • 7. Purpose of Adjustments Revenues are recorded when earned. Expenses are recorded when incurred. Because transactions occur over time, ADJUSTMENTS are required at the end of each fiscal period to get the revenues and expenses into the “right” period. Matching Principle
    • 8. Types of Adjustments
    • 9. Adjustment Process
    • 10. Unearned Revenues
      • Papa John’s received cash last period and recorded an increase in Cash and increase in Unearned Franchise Fees, a liability, to recognize the business’s obligation to provide future services to franchisees. During January, Papa John’s performed $1,100 in services for franchisees who had previously paid fees.
    • 11. Accrued Revenues
      • Papa John’s franchisees owe Papa John’s $830 in royalties for sales the franchisees made in the last week of January. The cash will be received in the future.
    • 12. Accrued Revenue
      • Papa John’s loaned $3,000 to franchisees on December 31 (one month ago) at 6 percent interest per year with interest to be paid at the end of each year. There was also $8,000 in notes receivable outstanding all month from prior loans. There are two components when lending or borrowing money: principal (the amount loaned or borrowed) and interest (the cost of borrowing). Notes Receivable (the principal) was recorded properly when the money was loaned.
    • 13. Accrued Revenue
      • Papa John’s loaned $3,000 to franchisees on December 31 (one month ago) at 6 percent interest per year with interest to be paid at the end of each year. There was also $8,000 in notes receivable outstanding all month from prior loans. There are two components when lending or borrowing money: principal (the amount loaned or borrowed) and interest (the cost of borrowing). Notes Receivable (the principal) was recorded properly when the money was loaned.
    • 14. Deferred Expenses Prepaid Expenses includes $2,000 paid on January 1 for insurance coverage for four months (January through April) and $6,000 paid on January 1 for rental of space at shopping centers over three months (January through March). Compute the amount of expense incurred . One month has expired for each of the prepaid amounts: Insurance: $2,000 x 1 month/4 months = $ 500 used in January. Rent: $6,000 x 1 month/3 months = $2,000 used in January.
    • 15. Deferred Expenses Prepaid Expenses includes $2,000 paid on January 1 for insurance coverage for four months (January through April) and $6,000 paid on January 1 for rental of space at shopping centers over three months (January through March).
    • 16. Prepaid Expenses
      • Supplies include food and paper products. At the end of the month, Papa John’s counted $12,000 in supplies on hand, but the Supplies account indicated a balance of $16,000. We need to determine the supplies used during the current accounting period.
    • 17. Prepaid Expenses
      • Supplies include food and paper products. At the end of the month, Papa John’s counted $12,000 in supplies on hand, but the Supplies account indicated a balance of $16,000. We need to determine the supplies used during the current accounting period.
    • 18. Prepaid Expenses Property and equipment are assets that have a normal debit balance. Depreciation is the allocation of the cost of an asset over its estimated useful life to the company. Depreciation is an expense with a normal debit balance. When we record depreciation we credit a “contra asset account” called Accumulated Depreciation. Contra-accounts are accounts that are directly linked to another account, but with an opposite balance. We subtract accumulated depreciation from the cost of our property and equipment to arrive at net book value.
    • 19. Prepaid Expenses Papa John’s estimates depreciation to be $30,000 per year. $30,000 ÷ 12 months = $2,500 per month depreciation expense
    • 20. Accrued Expenses
      • Amounts for Accrued Expenses:
      • Salaries = $500 per day × 4 days = $2,000
      • Utilities = $610
      • Interest = $138,000 × .06 × 1/12 = $690
      Papa John’s owed (1) its employees salaries for working four days at the end of January at $500 per day, (2) $610 for utilities used in January, and (3) interest on its long-term notes payable borrowed at a 6 percent annual rate.
    • 21. Accrued Expenses Papa John’s owed (1) its employees salaries for working four days at the end of January at $500 per day, (2) $610 for utilities used in January, and (3) interest on its long-term notes payable borrowed at a 6 percent annual rate. estimates depreciation to be $30,000 per year.
    • 22. Accrued Expenses
      • The final adjusting journal entry is to record the accrual of income taxes that will be paid in the next quarter. This requires computing adjusted pretax income (that is, balances from the unadjusted trial balance plus the effects of all of the other adjustments):
      From our unadjusted trial balance shown earlier.
    • 23. Accrued Expenses Papa John’s average income tax rate is 34 percent. So, the estimated amount of the taxes on this income that will be at the end of the quarter is $11,500 × .34 = $3,910.
    • 24. Ethics and Adjusting Entries
    • 25. Preparing Financial Statements
      • Before we prepare a complete set of financial statements, let’s update the trial balance to reflect the adjustments and provide us with adjusted balances for the statements.
      • Income statement,
      • Statement of stockholders’ equity,
      • Balance sheet, and
      • Statement of cash flows.
    • 26.  
    • 27. Financial Statement Relationships
    • 28. Income Statement This is the income statement drawn from the adjusted trial balance. Refer back to the adjusted trial balance and trace the income statement numbers forward. Notice that gains and losses are reported in the Other Items section of the statement.
    • 29. Earnings Per Share You will note that the earnings (EPS) ratio is reported on the income statement. It is widely used in evaluating the operating performance and profitability of a company $7,590,000 Net Income ÷ 28,1000,000 Shares = $0.27 Earnings Per Share Net Income Average Number of Common Shares Outstanding during the Period =
    • 30. Statement of Stockholders’ Equity
      • Net income appears on the statement of stockholders’ equity as an increase in Retained Earnings.
      From the income statement Will appear on the balance sheet
    • 31.  
    • 32. Focus on 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 .
    • 33. Focus on Cash Flows
      • Disclosures
      • Cash interest paid.
      • Cash income taxes paid.
      • A schedule of significant noncash investing and financing transactions .
    • 34. Key Ratio Analysis Net Profit Margin indicates how effective management is at generating profit on every dollar of sales. Net Income Net Sales Net Profit Margin = Net profit margin for Papa John’s for 2008 is: $36,796,000 $1,132,087,000 = .0325 = 3.25%
    • 35. Closing the Books
      • 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.
    • 36. Closing the Books Here is an example of the closing process using an illustration with just a few accounts.
    • 37. Closing Entries for Papa John’s Transfer net income to Retained Earnings.
    • 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.
    • 39. End of Chapter 04

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