Accounting & Financial Reporting

1. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Adjustments,
Financial
Statements,
and the
Quality of Earnings
Chapter 4

2. 4-2
Business Background
Management is
responsible for
preparing . . .
. . . Are useful
to investors
and creditors.
Financial
Statements
High Quality
= Relevance
+ Reliability

3. 4-3
Business Background
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.

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

5. 4-5
Learning Objectives
Explain the purpose of a trial balance.

6. 4-6
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.

7. 4-7
Matrix, Inc.
Unadjusted Trial Balance
At December 31, 2006
Description Debit Credit
Cash 3,900
$
Accounts receivable 4,985
Inventory 3,300
Equipment 4,800
Accumulated depreciation - Equip. 1,440
$
Furniture and fixtures 6,600
Accumulated depreciation - furn. & fix. 2,200
Accounts payable 2,985
Notes payable 4,000
Common stock 10,000
Retained earnings, 12/31/05 1,760
Sales revenue 35,000
Cost of goods sold 27,500
Operating expenses 6,300
Totals 57,385
$ 57,385
$
Note that
total debits =
total credits

8. 4-8
Matrix, Inc.
Unadjusted Trial Balance
At December 31, 2006
Description Debit Credit
Cash 3,900
$
Accounts receivable 4,985
Inventory 3,300
Equipment 4,800
Accumulated depreciation - Equip. 1,440
$
Furniture and fixtures 6,600
Accumulated depreciation - furn. & fix. 2,200
Accounts payable 2,985
Notes payable 4,000
Common stock 10,000
Retained earnings, 12/31/05 1,760
Sales revenue 35,000
Cost of goods sold 27,500
Operating expenses 6,300
Totals 57,385
$ 57,385
$
Accumulated depreciation
is a contra-asset account.
It is directly related to an
asset account but has the
opposite balance.

9. 4-9
Matrix, Inc.
Unadjusted Trial Balance
At December 31, 2006
Description Debit Credit
Cash 3,900
$
Accounts receivable 4,985
Inventory 3,300
Equipment 4,800
Accumulated depreciation - Equip. 1,440
$
Furniture and fixtures 6,600
Accumulated depreciation - furn. & fix. 2,200
Accounts payable 2,985
Notes payable 4,000
Common stock 10,000
Retained earnings, 12/31/05 1,760
Sales revenue 35,000
Cost of goods sold 27,500
Operating expenses 6,300
Totals 57,385
$ 57,385
$
Cost - Accumulated depreciation =
BOOK VALUE.

10. 4-10
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,
or in copying ending balances
from the ledger to the
trial balance.

11. 4-11
Learning Objectives
Analyze the adjustments necessary at the end
of the period to update balance sheet and
income statement accounts.

12. 4-12
Adjusting Entries
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.

13. 4-13
End of
accounting period.
Cash received
or paid.
Revenues earned
or
expense incurred.
Examples include interest earned during the period
(accrued revenue) or wages earned by employees but
not yet paid (accrued expense).
Proper Recognition of Revenues and Expenses

14. 4-14
Recognizing Revenues in the Proper Period
When cash is
received prior to
earning revenue by
delivering goods or
services, the
company records a
journal entry to
recognize
unearned revenue.

15. 4-15
End of
accounting period.
Cash received. Revenues earned.
Example includes rent received in
advance (an unearned revenue).
Deferred Revenue

16. 4-16
Deferred Revenue
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 . . .
GENERAL JOURNAL
Date Description Debit Credit
Dec 1 Cash 3,000
Unearned Rent Revenue 3,000
This is a LIABILITY account

17. 4-17
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

18. 4-18
Deferred Revenue
On December 31, 2006, Tom’s Rentals must adjust the
Unearned Rent Revenue account to reflect that one
month of rent revenue has been earned.
$3,000 × 1/4 = $750 per month.
GENERAL JOURNAL
Date Description Debit Credit
Dec 31 Unearned Rent Revenue 750
Rent Revenue 750
In effect, our obligation to let them occupy the space for a
period of time has decreased because they used the
space for one month.

19. 4-19
Deferred Revenue
After we post the entry to the T-accounts, the
account balances look like this:
Unearned Rent
Revenue
12/31 750 12/1 3000
Bal. 2,250
Rent Revenue
12/31 750
Bal. 750

20. 4-20
Accrued Revenues
When revenues are
earned but not yet
recorded at the end of
the accounting period
because cash changes
hands after the service is
performed or goods
delivered

21. 4-21
End of
accounting period.
Cash received
Revenues earned
Example includes interest earned
during the period (accrued revenue).
Accrued Revenue

22. 4-22
GENERAL JOURNAL
Date Description Debit Credit
Dec 31 ?
?
What Should Webb's
Entry Be?
GENERAL JOURNAL
Date Description Debit Credit
Dec 31 Interest Receivable 150
Interest Revenue 150
$10,000 × 6% × 3/12 = $150
Accrued Revenue
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.

23. 4-23
Accrued Revenue
After we post the entry to the T-accounts, the
account balances look like this:
Interest
Receivable
12/31 150
Bal. 150
Interest Revenue
12/31 150
Bal. 150

24. 4-24
Chart for Deferred and Accrued Revenues
Deferred Revenue Accrued Revenue
Cash (+A)
Unearned revenue (+L)
Unearned revenue (-L) Revenue receivable (+A)
Revenue (+R, + SE) Revenue (+R, +SE)
Cash (+A)
Revenue receivable (-A)
During the period
End of the period
Next period
None
None
Cash is received
Cash received before revenue earned
Company has earned revenue

25. 4-25
Recognizing Expenses in the Proper Period
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.

26. 4-26
End of
accounting period.
Cash paid.
Examples include prepaid rent, advertising,
and insurance.
Deferred Expense
Expense incurred.

27. 4-27
Deferred Expense
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 . . .
GENERAL JOURNAL
Date Description Debit Credit
Jan. 1 Prepaid Insurance Expense 3,600
Cash 3,600
This is an
ASSET account

28. 4-28
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 >

29. 4-29
Deferred Expense
On December 31, 2006, 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.
GENERAL JOURNAL Page 365
Date Description Debit Credit
Dec 31 Insurance Expense 1,200
Prepaid Insurance Exp. 1,200
In effect, the prepaid asset goes down▼,
while the expense goes up▲.

30. 4-30
Deferred Expense
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
Remaining two years of insurance
at $1,200 per year.

31. 4-31
Accrued Expenses
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.

32. 4-32
GENERAL JOURNAL
Date Description Debit Credit
Dec 31 ?
?
What Should Denton's
Entry Be on 12/31/04?
GENERAL JOURNAL
Date Description Debit Credit
Dec 31 Wages Expense 50,000
Wages Payable 50,000
Accrued Expenses
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.

33. 4-33
Accrued Expenses
After we post the entry to the T-accounts, the
account balances look like this:
Wages Payable
12/31 50,000
Bal. 50,000
Wages Expense
$1,900,000
Bal. $1,950,000
As of
12/27
12/31 50,000

34. 4-34
Chart for Deferred and Accrued Expenses
Deferred Expense Accrued Expense
Prepaid asset (+A)
Cash (-A)
Expense (+E) Expense (+E)
Prepaid asset ((-A) Liability (+L)
Liability (-L)
Cash (-A)
During the period
End of the period
Next period
None
None
Cash is paid after expense incurred
Cash paid before expense incurred
Company must recognize expense

35. 4-35
 Certain circumstances require
adjusting entries to record accounting
estimates.
 Examples include . . .
 Depreciation
 Bad debts
 Income taxes $$$
Adjustments Involving Estimates

36. 4-36
 Certain circumstances require
adjusting entries to record accounting
estimates.
 Examples include . . .
 Depreciation
 Bad debts
 Income taxes
Adjustments Involving Estimates
Let’s look at the
adjustment for
depreciation
expense.

37. 4-37
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.

38. 4-38
Depreciation Adjustment
The journal entry required is to debit
Depreciation Expense and to credit an account
called Accumulated Depreciation.
GENERAL JOURNAL Page 352
Date Description Debit Credit
Dec 31 Depreciation Expense $$$$
Accumulated Depreciation $$$$
This is called a Contra-Asset
account.
GENERAL JOURNAL Page 352
Date Description Debit Credit
Dec 31 Depreciation Expense $$$$
Accumulated Depreciation $$$$

39. 4-39
GENERAL JOURNAL
Date Description Debit Credit
Jan 31 ?
?
What Should Papa John's
Entry Be on 1/31/04?
GENERAL JOURNAL
Date Description Debit Credit
Jan 31 Depreciation Expense 2,500
Accumulated Depreciation 2,500
Depreciation Adjustment
At January 1, 2004, Papa John’s trial balance
showed Accumulated Depreciation of
$149,000 (in thousands of dollars). For the
month of January, Papa John’s needs to
recognize $2,500 in depreciation.

40. 4-40
Depreciation Adjustment
After we post the entry to the T-accounts, the
account balances look like this (in thousands
of dollars):
1/31 2,500
Bal. 151,500
Accumulated
Depreciation
Depreciation
Expense
1/31 2,500
Bal. 2,500
1/1 149,000

41. 4-41
Learning Objectives
Present an income statement with earnings
per share, statement of stockholders’ equity,
and balance sheet, and supplemental cash
flow information.

42. 4-42
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.

43. 4-43
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.
Financial Statement Relationships
RETAINED
EARNINGS
REVENUES EXPENSES
–
NET
INCOME =
DIVIDENDS
Decrease
Increase

44. 4-44
STOCKHOLDERS’
EQUITY
Financial Statement Relationships
CONTRIBUTED
CAPITAL
RETAINED
EARNINGS
Contributed Capital and
Retained Earnings make
up Stockholders’ Equity.
Increase
REVENUES EXPENSES
–
NET
INCOME =
Increase

45. 4-45
Financial Statement Relationships
CONTRIBUTED
CAPITAL
RETAINED
EARNINGS
ASSETS LIABILITIES
STOCKHOLDERS’
EQUITY
= +
Increase
REVENUES EXPENSES
–
NET
INCOME =
Increase

46. 4-46
Papa John's International, Inc. and Subsidiaries
Consolidated Statement of Income
Month Ended January 31, 2004
(in thousands of dollars)
Revenues:
Restaurant sales 66,000
$
Franchise fees 3,800
Total revenues 69,800
Costs and expenses:
Cost of sales 36,000
Salaries & benefits expense 16,000
General & administrative expenses 8,100
Depreciation expense 2,500
Total costs and expenses 62,600
Operating income 7,200
Other revenues and gains (expenses and losses)
Investment income 1,000
Interest expense (60)
Gain on sale of land 3,000
Income before income taxes 11,140
Income tax expense 3,899
Net income 7,241
$
Earnings per share 0.40
$
The income
statement contains
revenues and
expenses.
Earnings Per
Share (EPS) must
be reported on
the income
statement.

47. 4-47
Statement of Stockholders’ Equity
Net income appears on the statement of stockholders’
equity as an increase in Retained Earnings.
Papa John's International, Inc. and Subsidiaries
Consolidated Statement of Stockholders' Equity
For the Month Ended January 31, 2004
(in thousands of dollars)
Contributed
Capital
Retained
Earnings
Stockholders'
Equity
Beginning balance,
12/28/03 1,000
$ 158,000
$ 159,000
$
Stock Issuance 2,000 2,000
Net income 7,241 7,241
Dividends (3,000) (3,000)
Ending balance,
1/31/04 3,000
$ 162,241
$ 165,241
$
From the
Income
Statement

48. 4-48
Balance Sheet - Assets
Papa John's International, Inc. & Subsidiaries
Consolidated Balance Sheet
January 31, 2004
(in thousands of dollars)
Assets
Current Assets:
Cash 37,900
$
Accounts receivable 17,100
Supplies 12,000
Prepaid expenses 17,500
Other current assets 7,000
Total current assets 91,500
Long-term investments 9,000
Property and equipment (net of
accumulated depreciation of $151,500) 210,500
Long-term notes receivable 14,000
Intangibles 49,000
Other assets 13,000
Total assets 387,000
$
$362,000 cost –
$151,500
accumulated
depreciation is
equal to $210,500.

49. 4-49
Balance Sheet – Liabilities & Stockholders’
Equity
Papa John's International, Inc. & Subsidiaries
Consolidated Balance Sheet
January 31, 2004
(in thousands of dollars)
Liabilities and stockholders' equity
Current liabilities
Accounts payable 38,000
$
Dividends payable 3,000
Accrued expenses payable 55,660
Income taxes payable 3,899
Total current liabilities 100,559
Unearned franchise fees 6,200
Long-term notes payable 75,000
Other long-term liabilities 40,000
Total liabilities 221,759
Stockholders' equity
Contributed capital 3,000
Retained earnings 162,241
Total stockholders' equity 165,241
Total liabilities and stockholders'
equity $ 387,000
From the
statement of
Stockholders’
Equity.

50. 4-50
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 . . .
1. Operating activities,
2. Investing activities, and
3. Financing activities.

51. 4-51
Statement of Cash Flows
Effect on Cash Flows
Operating activities +/–
Investing activities +/–
Financing activities +/–
Changes in cash
Total net cash flows for
the period
+ Beginning cash balance +
= Ending cash balance Total
Supplemental Disclosure: (1) Interest paid, (2) income taxes
paid, and (3) a listing of the nature and amounts of significant
noncash transactions.

52. 4-52
Learning Objectives
Compute and interpret the net profit margin.

53. 4-53
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%

54. 4-54
Learning Objectives
Explain the closing process.

55. 4-55
Closing the Books
Even though the
balance sheet
account balances
carry forward from
period to period, the
income statement
accounts do not.
Closing entries:
1. Transfer net income (or
loss) to Retained
Earnings.
2. Establish a zero balance
in each of the temporary
accounts to start the next
accounting period.

56. 4-56
Closing the Books
The following accounts are called
temporary or nominal accounts and are
closed at the end of the period . . .
• Revenues.
• Expenses.
• Gains.
• Losses.
• Dividends declared.

57. 4-57
Closing the Books
Assets, liabilities, and stockholders’ equity
are permanent, or real accounts, and are
never closed.
 Assets.
 Liabilities.
 Stockholders’ Equity.

58. 4-58
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.

59. 4-59
GENERAL JOURNAL Page 365
Date Description Debit Credit
Jan 31 Restaurant Sales Revenue 66,000
Retained Earnings 66,000
To close Papa John’s Restaurant Sales Revenue
account, the following entry is required:
158,000 12/28/03
66,000 Close
Retained Earnings
66,000 66,000
Sales Revenue
Restaurant
Closing the Books

60. 4-60
158,000 12/28/03
66,000 Close
3,800 Close
1,000 Close
3,000 Close
Retained Earnings
Closing the Books
If we close the
other revenue
accounts in a
similar fashion,
the retained
earnings
account looks
like this . . .

61. 4-61
GENERAL JOURNAL Page 365
Date Description Debit Credit
Jan 31 Retained Earnings 30,000
Cost of Sales - Restaurants 30,000
To close Papa John’s Cost of Sales - Restaurants
account, the following entry is required:
30,000 30,000 Close
Restaurants
Cost of Sales
30,000
Retained Earnings
Closing the Books

62. 4-62
Closing the Books
If we close the
other expense
accounts in a
similar fashion,
the retained
earnings
account looks
like this . . .
Close 30,000 158,000 12/28/03
Close 16,000 66,000 Close
Close 7,000 3,800 Close
Close 4,000 1,000 Close
Close 2,000 3,000 Close
Close 500
Close 600
Close 2,500
Close 60
Close 3,899
Retained Earnings

63. 4-63
Closing the Books
Assume that
dividends declared
are recognized in a
separate dividend
account, which is
closed to Retained
Earnings at the end
of the period.
Close 30,000 158,000 12/28/03
Close 16,000 66,000 Close
Close 7,000 3,800 Close
Close 4,000 1,000 Close
Close 2,000 3,000 Close
Close 500
Close 600
Close 2,500
Close 60
Close 3,899
Close 3,000
162,241 Ending Bal.
Retained Earnings

64. 4-64
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.

65. 4-65
Post-Closing Trial Balance
Matrix, Inc.
Adjusted Trial Balance
At December 31, 2004
Description Debit Credit
Cash 3,900
$
Accounts receivable 4,985
Inventory 3,300
Equipment 4,800
Accumulated depreciation - Equip. 1,440
$
Furniture and fixtures 6,600
Accumulated depreciation - furn. & fix. 2,200
Accounts payable 2,985
Notes payable 4,000
Common stock 10,000
Retained earnings, 1/1/04 1,760
Sales revenue 35,000
Cost of goods sold 27,500
Operating expenses 6,300
Totals 57,385
$ 57,385
$
Close these
accounts. Net
income is $1,200

66. 4-66
Post-Closing Trial Balance
Matrix, Inc.
Post-Closing Trial Balance
At December 31, 2004
Description Debit Credit
Cash 3,900
$
Accounts receivable 4,985
Inventory 3,300
Equipment 4,800
Accumulated depreciation - Equip. 1,440
$
Furniture and fixtures 6,600
Accumulated depreciation - furn. & fix. 2,200
Accounts payable 2,985
Notes payable 4,000
Common stock 10,000
Retained earnings, 12/31/04 2,960
Sales revenue -
Cost of goods sold -
Operating expenses -
Totals 23,585
$ 23,585
$
Retained earnings
$2,960
($1,760 + $1,200
net income).

67. 4-67
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.

68. 4-68
End of Chapter 4