Chapter 4: Adjustments, Financial Statements, and the Quality of Earnings.
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.
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.
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.
Our first learning objective in Chapter 4 is to explain the purpose of the trial balance.
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’s an example of the trial balance at the end of the year. Notice that the total of all the debits is equal to the total of all the credits.
Two of the accounts listed on our trial balance are accumulated depreciation associated with the equipment as well as associated with furniture and fixtures. Accumulated depreciation is a contra asset account. A contra asset account is directly related to an asset account and reduces that account balance.
For example, if we take the balance in the equipment account and subtract the accumulated depreciation we have what is known as the “book value” of the asset. The contra account, accumulated depreciation on equipment, reduces the equipment account balance on the financial statements.
If the total debits are not equal to the total credits on our trial balance, we’ve made an accounting error. While it’s impossible to specify exactly what the error is, we’ve listed three possibilities. First, we may have prepared a journal entry where the debits and credits were not equal. Second, we may have made an error in posting from the journal to the ledger. Finally, we may have made an error in entering the ending account balances on our trial balance.
Our second learning objective in Chapter 4 is to analyze the adjustments necessary at the end of the period to update balance sheet and income statement accounts.
There are two types of adjusting entries: accruals and deferrals. Accruals are for those events where revenues have been earned or expenses incurred but they have not been recorded in the journal. Deferrals represent the receipt of assets or the payment of cash in advance of the revenue being earned or the expense being recognized.
Here is a schematic showing the problem of adjusting entries when transactions cross-over accounting periods.
Let’s see what steps we have to take to recognize revenue in the proper accounting period. When a company receives cash prior to the earning of revenue, an unearned revenue account must be recognized. The unearned revenue account is a liability account. Revenue cannot be recognized until the goods are delivered or the services are provided.
Here is an example of cash being received in one accounting period, but the revenue is not earned until the following accounting period. An example of this type of transaction would include rent received in advance.
In this example, Tom’s Rentals received a check for $3,000 representing the first four months rent from a new tenant. Since no service has been provided to the new tenant we must recognize an unearned revenue account. The journal entry at December 1 is to debit cash for $3,000 and credit unearned rent revenue for the same amount. The unearned rent revenue account is a liability account.
This diagram demonstrates how rent received in advance will be earned. We will earn one-fourth of the total for the month beginning December 1 and ending December 31, 2004, then one-fourth of the total for the month beginning January 1, 2005 and ending January 31, 2005. The final amount will be earned for the month of March 2005.
On December 31 st it’s necessary to make an adjusting entry to recognize the revenue earned as a result of providing services to our tenant. The entry is to recognize one-fourth of the total unearned rent revenue. The journal entry at December 31 is to debit unearned rent revenue for $750 and credit rent revenue for $750. Our journal entry reduces the liability, unearned rent revenue, and recognizes our revenue earned.
The journal entry to T-accounts for unearned rent revenue and rent revenue looks like this. The rent revenue will appear on the income statement for the month ended December 31, 2004. Any unearned rent revenue will appear as a liability on our balance sheet.
Accrued revenue occurs when revenue has been earned but not recorded in our books.
Here is a demonstration of revenue being earned in one accounting period, but the cash is not received until the following accounting period. An example would include interest earned on a savings account balance.
Part I On October 1, 2006 Webb invested $10,000 for six months in a certificate of deposit that pays 6% annual interest. Webb does not receive the interest until the CD matures in March of 2007. What journal entry would Webb have to make at December 31, 2006, to show the amount of interest actually earned during December? Part II The appropriate journal entry at December 31 is to debit interest receivable for $150 and credit interest revenue for the same amount. You can see the calculation of the interest earned for the three months of October, November and December. The interest receivable account is an asset account and will appear on our balance sheet. The interest revenue will appear on our income statement for the current period.
After posting the adjusting journal entry at December 31, the two T-accounts will each have a balance of $150.
This chart provides you with an overview of accounting for deferred and accrued revenues.
Our next problem addresses the proper recognition of expenses. We know that expenses should be recognized when incurred, not necessarily when cash is paid.
A deferred expense is one in which cash is paid before the expense is recognized. Examples would include prepaid rent or prepaid advertising.
On January 1, 2006 a company pays $3,600 cash for a three-year fire insurance policy. On the date the policy is acquired the company will debit prepaid insurance expense for $3,600 and credit cash for the same amount. The prepaid insurance expense is an asset account and will appear on our balance sheet.
The insurance policy will expire over the next three years and the company will receive one-third of the total cost as a benefit in each of those three years. What adjusting journal entry do you think we’ll need to make at December 31, 2006?
The adjusting journal entry is to debit insurance expense for $1,200 and credit prepaid insurance expense for the same amount. The asset account, prepaid insurance expense, will be reduced and our expenses will go up by $1,200.
Immediately after posting the adjusting entry, the balance in prepaid insurance expense will be $2,400. This represents the remaining two years of unexpired insurance. The prepaid interest expense is an asset account and will appear on our balance sheet. The insurance expense will appear on our income statement for the current period.
Accrued expenses are expenses that are incurred in the current period but are not billed or paid until the next accounting period. Common examples include interest expense, wages payable to our employees, and utility expenses.
Part I On December 27, 2006, Denton had already paid $1,900,000 to its employees as wages for the year. Denton pays its employees every Friday, but this year December 31, 2006, falls on a Wednesday. As of the end of the year, employees earned a total of $50,000 in wages but they will not be paid until the end of the week, Friday, January 2, 2007. What adjusting journal entry do you think is necessary at December 31, 2006? Part II On December 31, 2006 Denton will debit wages expense for $50,000 and credit wages payable for the same amount.
After we post the adjusting journal entry, the balance in wages expense will be $1,950,000. Of course, wages expense will appear on our current period income statement. Wages payable is a liability and will appear on our balance sheet.
Here is a chart that summarizes the proper accounting for deferred and accrued expenses.
In addition to the adjustments we’ve already discussed, we also have adjustments involving estimates. Examples of common accounting estimates would include depreciation expense, bad debt expense and income taxes expense.
Let’s begin by looking at the adjustment required for depreciation expense.
Depreciation is a systematic and rational allocation of the cost of the productive asset over its estimated useful life. Depreciation is the concept of cost allocation, not a concept of valuation.
The general journal entry to record depreciation expense is to debit depreciation expense and credit accumulated depreciation. Remember, we previously discussed that accumulated depreciation is a contra asset account. It will appear on our balance sheet and reduce the cost basis of the related property, plant or equipment.
Part I On the January 31, 2004, trial balance of Papa John’s, there were $362,000 of property and equipment. The balance in the accumulated depreciation account was $149,000. For the current period, Papa John’s needs to record additional depreciation of $2,500. What is the journal entry required to make this adjustment? Part II Papa John’s should debit depreciation expense for $2,500 and credit accumulated depreciation for the same amount.
After we post the adjusting entry, the new balance in the accumulated depreciation account will be $151,500. The balance in the depreciation account is $2,500. The balance in the accumulated depreciation account will appear on our balance sheet as a reduction to the property and equipment account.
Our third learning objective in Chapter 4 is to present an income statement with earnings per share, statement of stockholders’ equity, and balance sheet, and supplemental cash flow information.
We know that we begin the process of preparing the financial statements with the income statement.
Part I Once the income statement has been prepared, we can move on to the statement of retained earnings. Part II Net income increases retained earnings, and dividends decrease retained earnings.
Retained earnings is combined with contributed capital to form stockholders’ equity.
Stockholders equity is one of the three major portions of our balance sheet. We know that assets equal liabilities plus stockholders’ equity.
Here is the income statement for Papa John’s for the month ended January 31, 2004. Notice that during the month, Papa John’s earned 40 cents per share. Net income is $7,241 and will flow forward to the statement of retained earnings.
Here is Papa John’s statement of stockholders’ equity for the month ended December 31, 2004. You can see that net income increases retained earnings and dividends decrease retained earnings. The balance in the retained earnings account is $162,241. This amount should flow forward to the stockholders’ equity section of our balance sheet.
On this slide we have the asset section of Papa John’s balance sheet at January 31, 2004. Notice that accumulated depreciation reduces the cost basis of property and equipment.
This is the liability and stockholders’ equity section of Papa John’s balance sheet. Notice that the balance in retained earnings is $162,241, the amount that flowed forward from the statement of stockholders’ equity.
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.
The operating, investing and financing activities sections determine the change in cash for the period. We then add the beginning balance in our cash account to arrive at the ending balance in our cash account. There are three supplemental disclosures required. The first is cash interest paid. Next is cash income taxes paid. And finally, we must disclose any non-cash investing and financing activities that are important to the reader of the statement. For example, the company may issue bonds to buy a building. No cash was involved in this transaction, but it may be significant enough to disclose in the notes to the financial statements.
Our fourth learning objective in Chapter 4 is to compute and interpret net profit margin.
Part I 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. Part II For the month ended January 31, 2004, Papa John’s net profit margin was 10.37%.
Our fifth learning objective in Chapter 5 is to explain the closing process.
All balance sheet accounts are carried forward from one period to the next, but income statement accounts are not . Income accrues over a period of time, so at the beginning of each new period we start accumulating revenues and expenses all over again. It is necessary to zero out all revenues, expenses, gains and losses at the end of each accounting period. We transfer all income accounts to retained earnings. We already know that net income increases retained earnings; the closing process is the way we transfer that income into the retained earnings account.
Only the accounts listed on this slide are closed. They include revenues, expenses, gains, losses, and dividends declared. All of these accounts are referred to as temporary accounts because we zero them out at the end of each accounting period. Balance sheet accounts are referred to as real accounts because they carryforward from one accounting period to the next.
Remember we never close asset, liability or stockholders’ equity accounts.
Closing our books is a two-step process. First, we close all revenue and gains to retained earnings. Second, we close all expenses and losses to retained earnings. Let’s see how this two-step process works.
Part I Revenues and gains both have a credit balance. To close a revenue or gain account, we must debit that account. So the entry to close out Papa John’s restaurant sales revenue is to debit restaurant sales revenue for $66,000, and credit retained earnings for $66,000. Part II After we post this closing entry, the restaurant sales revenue account will have a zero balance and the $66,000 will be transferred to retained earnings.
On this screen we merely show that other revenue and gain accounts have been closed and transferred to retained earnings.
Part I Expenses and losses have debit balances. To zero out an expense or loss account, we must credit the account and debit retained earnings. As you can see on the screen, Papa John’s closed its cost of goods sold with the debit to retained earnings for $30,000 and a credit to cost of sales for the same amount. We would close all other expenses in a similar manner. Part II After this closing entry has been posted, cost of sales has a zero balance and the $30,000 has been transferred to retained earnings.
Here we demonstrate the closing of other expense accounts on the debit side of the retained earnings account.
After all revenues, expenses, gains and losses have been closed. Assume that dividends declared are recognized in a separate dividend account. This separate account will be closed directly to retained earnings at the end of the period. The balance in retained earnings is $162,241. This is the amount that will appear on our balance sheet.
Let’s see the difference between the adjusted trial balance and post-closing trial balance of Matrix at December 31, 2004.
Here is our adjusted trial balance that contains revenue and expense accounts. We know that at the end of December we need to close all of our revenues, expenses, gains and losses accounts.
Here is our post-closing trial balance. Notice that all revenue and expense accounts have been zeroed out. The balance in retained earnings has been updated from $1,760 to $2,960. The difference between the two amounts is our net income of $1,200.
Companies that tend to make relatively pessimistic estimates that reduce current earnings are judged to have a conservative financial reporting strategy. Financial analysts and many investors prefer this strategy to any other. These companies are thought to have “high quality” earnings.
End of Chapter 4.
Adjustments, Financial Statements, and the Quality of Earnings Chapter 4
Business Background Management is responsible for preparing . . . . . . Are useful to investors and creditors. Financial Statements High Quality = Relevance + Reliability
Business Background Matching Principle 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.
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.
Proper Recognition of Revenues and Expenses End of accounting period. Examples include interest earned during the period (accrued revenue) or wages earned by employees but not yet paid (accrued expense). Cash received or paid. Revenues earned or expense incurred.
On December 1, 2006, Tom’s Rentals received a check for $3,000, for the first four months’ rent from a new tenant.
The entry on December 1, 2006, to record the receipt of the prepaid rent payment would be . . .
This is a LIABILITY account
Deferred Revenue 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. Received cash for rent < 4-month prepayment of rent > 12/1/06 12/31/06 Year end 2/28/07 1/31/07 3/31/07
On October 1, 2006, 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, 2007. On December 31, 2006, Webb, Inc. must make an entry for the interest earned so far.
When cash is paid prior to incurring an expense, the company records a journal entry to recognize an asset. An expense may be incurred in the current period but not paid until the next period. The company must recognize a liability.
Deferred Expense End of accounting period. Examples include prepaid rent, advertising, and insurance. Expense incurred. Cash paid.
On January 1, 2006, Matrix, 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, 2006, to record the policy on Matrix’s books would appear as follows . . .
This is an ASSET account
Deferred Expense At the end of 2006, 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. 1/1/06 12/31/06 Year end 12/31/07 Year end 12/31/07 Year end Paid cash for insurance < 3-year insurance policy >
Recall that accrued expenses are expenses incurred in the current period but not billed or paid until the next accounting period. Common examples are interest expense incurred on debt, wages expense owed to employees, and utilities expense.
As of 12/27/06, Denton, Inc. had already paid $1,900,000 in wages for the year. Denton pays its employees every Friday. Year-end, 12/31/06, falls on a Wednesday. The employees have earned total wages of $50,000 for Monday through Wednesday of the week ending 1/02/07.
Certain circumstances require adjusting entries to record accounting estimates.
Examples include . . .
Adjustments Involving Estimates Let’s look at the adjustment for depreciation expense.
Depreciation Adjustment The accounting concept of depreciation involves the systematic and rational allocation of the cost of a long-lived asset over multiple accounting periods it is used to generate revenue. This is a “cost allocation” concept, not a “valuation” concept. Market Value
Depreciation Adjustment The journal entry required is to debit Depreciation Expense and to credit an account called Accumulated Depreciation . This is called a Contra-Asset account.
The next step in the accounting cycle is to prepare the financial statements. . .
Statement of stockholders’ equity,
Balance sheet, and
Statement of cash flows.
Financial Statement Relationships The income statement is created first by determining the difference between revenues and expenses. Net income increases retained earnings (a net loss decreases retained earnings). Dividends decrease retained earnings. RETAINED EARNINGS DIVIDENDS REVENUES EXPENSES – NET INCOME = Decrease Increase
Financial Statement Relationships STOCKHOLDERS’ EQUITY CONTRIBUTED CAPITAL RETAINED EARNINGS Contributed Capital and Retained Earnings make up Stockholders’ Equity. Increase REVENUES EXPENSES – NET INCOME = Increase
Financial Statement Relationships CONTRIBUTED CAPITAL RETAINED EARNINGS ASSETS LIABILITIES STOCKHOLDERS’ EQUITY = + Increase REVENUES EXPENSES – NET INCOME = Increase
The income statement contains revenues and expenses. Earnings Per Share (EPS) must be reported on the income statement.
Learning Objectives Compute and interpret the net profit margin. LO4
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 January 2004 is: $7,241,000 $69,800,000 = 10.37%
Learning Objectives Explain the closing process. LO5
Assume that dividends declared are recognized in a separate dividend account, which is closed to Retained Earnings at the end of the period.
Post-Closing Trial Balance Let’s take a look at the adjusted trial balance of Matrix, Inc. at December 31, 2004. We want to see the difference between the adjusted trial balance and the post-closing trial balance.
Post-Closing Trial Balance Close these accounts. Net income is $1,200
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.