chapter 4 adjustments, financial statements, and the quality of earnings 9/07/04

Chapter 4

Adjustments, Financial Statements, and the Quality of Earnings

9/07/04

© 2004 The McGraw-Hill CompaniesMcGraw-Hill/Irwin

4-2

Business Background

Management is Management is responsible for responsible for preparing . . .preparing . . .

. . . Are useful . . . Are useful to investors to investors

and creditors.and creditors.

Financial Financial StatementsStatementsFinancial Financial

StatementsStatements

High Quality High Quality = Important, = Important, Timely and Timely and Reliable InfoReliable Info


4-3

Business Background

Revenues are recorded

when earned.

Revenues are recorded

when earned.

Expenses are recorded

when incurred.

Expenses are recorded

when incurred.

Because transactions occur over time, ADJUSTMENTS are Because transactions occur over time, ADJUSTMENTS are required at the end of each fiscal period to get the revenues required at the end of each fiscal period to get the revenues

and expenses in the “right” period.and expenses in the “right” period.

Because transactions occur over time, ADJUSTMENTS are Because transactions occur over time, ADJUSTMENTS are required at the end of each fiscal period to get the revenues required at the end of each fiscal period to get the revenues

and expenses in the “right” period.and expenses in the “right” period.


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Accounting Cycle

During the period: Analyze transactions. Record journal entries. Post amounts to general

ledger.

During the period: Analyze transactions. Record journal entries. Post amounts to general

ledger.

At the end of the period: Adjust revenues and

expenses (matching) within the period.

At the end of the period: Adjust revenues and

expenses (matching) within the period.

Close Books, i.e. revenues, gains, expenses, and losses to Retained Earnings

Close Books, i.e. revenues, gains, expenses, and losses to Retained Earnings

Prepare Financial Statements

Disseminate statements to users

Prepare Financial Statements

Disseminate statements to users


4-5

The Unadjusted Trial Balance (Giant T Account)

A listing of individual accounts, usually in financial statement order starting with balance sheet, then income statement.

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

Total debit account balances should = total credit account balances. (no TMIB!)

A listing of individual accounts, usually in financial statement order starting with balance sheet, then income statement.

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

Total debit account balances should = total credit account balances. (no TMIB!)


4-6

Note that total debits = total credits

Note that total debits = total credits


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Accumulated depreciation is a contra-asset account. It is directly related to an asset account but has the opposite balance.

Accumulated depreciation is a contra-asset account. It is directly related to an asset account but has the opposite balance.


4-8

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

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


4-9Now that we havecovered the trial

balance, let’sdiscuss adjusting

entries.


4-10

Adjusting Entries

There are two types of adjusting entries.

ACCRUALSACCRUALS

Revenues earned or expenses

incurred that have not been

previously recorded.

Revenues earned or expenses

incurred that have not been

previously recorded.

DEFERRALSDEFERRALS

Receipts of assets (cash) or

payments of cash made in

advance of revenue or

expense recognition.

Receipts of assets (cash) or

payments of cash made in

advance of revenue or

expense recognition.


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End of accounting period.

Cash is receivedor paid in current period.

Revenues earnedor expense incurredin subsequent period

Examples include rent received in advance (an Examples include rent received in advance (an unearned revenue) or insurance paid in unearned revenue) or insurance paid in

advance (a prepaid expense).advance (a prepaid expense).

Examples include rent received in advance (an Examples include rent received in advance (an unearned revenue) or insurance paid in unearned revenue) or insurance paid in

advance (a prepaid expense).advance (a prepaid expense).

Deferrals (of revenue or expense recognition)


4-12

Prepaid Expense - Example 1

On January 1, 2003, Tipton, 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, 2003, to record the policy on Tipton’s books would appear as follows . . .

On January 1, 2003, Tipton, 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, 2003, to record the policy on Tipton’s books would appear as follows . . .

This is an ASSETASSET account

This is an ASSETASSET account


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At the end of 2003, we determine how much At the end of 2003, we determine how much of the “prepaid expense” has been used up of the “prepaid expense” has been used up

during the period. during the period. Since the policy is for Since the policy is for 3 years3 years, we can , we can

assume that 1/3 of the policy will expire assume that 1/3 of the policy will expire each year. each year.

At the end of 2003, we determine how much At the end of 2003, we determine how much of the “prepaid expense” has been used up of the “prepaid expense” has been used up

during the period. during the period. Since the policy is for Since the policy is for 3 years3 years, we can , we can

assume that 1/3 of the policy will expire assume that 1/3 of the policy will expire each year. each year.

1/1/03 12/31/03Year end

12/31/04Year end

12/31/05Year end

Paid cash forinsurance

< 3-year insurance policy >


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On December 31, 2003, 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.

On December 31, 2003, 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.

In effect, the prepaid asset goes down, while the expense goes up.

In effect, the prepaid asset goes down, while the expense goes up.


4-15


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


Prepaid Insurance(Balance sheet)

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

Bal. 2,400

(IncomeStatement)

12/31 1,200

Bal. 1,200

Insurance Expense


4-16

Deferrals

Now, let’s look at an

example of

cash received

in advance.


4-17

Unearned Revenue - Example 2

On December 1, 2003, Tom’s Rentals received a check for $3,000, for the first four months’ rent of a new

tenant.

The entry on December 1, 2003, to record the receipt of the prepaid rent payment would be . . .

On December 1, 2003, Tom’s Rentals received a check for $3,000, for the first four months’ rent of a new

tenant.

The entry on December 1, 2003, to record the receipt of the prepaid rent payment would be . . .

This is a LIABILITY accountThis is a LIABILITY account


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We must record the amountWe must record the amountof rent of rent EARNEDEARNED during December. during December.

Since the prepayment is for Since the prepayment is for 4 4 monthsmonths, we can assume that 1/4 of , we can assume that 1/4 of the rent will be earned each month. the rent will be earned each month.

We must record the amountWe must record the amountof rent of rent EARNEDEARNED during December. during December.

Since the prepayment is for Since the prepayment is for 4 4 monthsmonths, we can assume that 1/4 of , we can assume that 1/4 of the rent will be earned each month. the rent will be earned each month.

Received cash for rent

< 4-month prepayment of rent >

12/1/03 12/31/03Year end

2/28/041/31/04 3/31/04


4-19


On December 31, 2003, Tom’s Rentals must adjust the Unearned Rent Revenue account to reflect that 1

month of rent revenue has been earned.

$3,000 × 1/4 = $750 per month.

On December 31, 2003, Tom’s Rentals must adjust the Unearned Rent Revenue account to reflect that 1

month of rent revenue has been earned.

$3,000 × 1/4 = $750 per month.

In effect, our obligation to let them occupy the space for a period of has decreased, because they used the space for 1

month.

In effect, our obligation to let them occupy the space for a period of has decreased, because they used the space for 1

month.


4-20




Unearned Rent Revenue (BS)

12/31 750 12/1 3000

Bal. 2,250

Rent Revenue (IS)

12/31 750

Bal. 750


4-21

Accruals (recognizing revenue and expense)

Now, we need to look at adjusting entries for accruals.

Now, we need to look at adjusting entries for accruals.


4-22

Accruals

Accruals occur when revenues

have been earned or expenses

incurred but no no cash cash has been exchanged or receivables or

payables set up.

Accruals occur when revenues

have been earned or expenses

incurred but no no cash cash has been exchanged or receivables or

payables set up.


4-23

End of accounting period.

Cash receivedor paid in

subsequent period.

Revenues earnedor expense incurred

in current period

Examples include interest earned during the period (accrued revenue) or wages earned by employees but

not yet paid (accrued expense).

Examples include interest earned during the period (accrued revenue) or wages earned by employees but

not yet paid (accrued expense).

Accruals


4-24

Accrued Revenue - Example 1

On October 1, 2003, 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, 2004. On December 31, 2003, Webb, Inc. must make an entry for the interest earned

so far.

On October 1, 2003, 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, 2004. On December 31, 2003, Webb, Inc. must make an entry for the interest earned

so far.


4-25

Accrued Revenue - Example 1



Interest Receivable (BS)

12/31 150

Bal. 150

Interest Revenue (IS)

12/31 150

Bal. 150


4-26

Accrued Expenses - Example 2

As of 12/27/03, Denton, Inc. had already paid $1,900,000 in wages for the year. Denton pays its employees

every Friday. Year-end, 12/31/03, falls on a Wednesday. The employees have earned total wages

of $50,000 for Monday through Wednesday of the week ended 1/02/04.

As of 12/27/03, Denton, Inc. had already paid $1,900,000 in wages for the year. Denton pays its employees

every Friday. Year-end, 12/31/03, falls on a Wednesday. The employees have earned total wages

of $50,000 for Monday through Wednesday of the week ended 1/02/04.


4-27

Accrued Expenses

After we post the entry to the T accounts,

the account balances look like this:

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


4-28

Certain circumstances require adjusting entries to record accounting estimates.

Examples include . . .DepreciationBad debtsIncome taxes

Certain circumstances require adjusting entries to record accounting estimates.

Examples include . . .DepreciationBad debtsIncome taxes

$$$

Accounting Estimates


4-29

Depreciation

The accounting concept of

depreciation involves the

systematic and rational allocation of a long-lived asset’s cost to the multiple periods it is used to

generate revenue(matching principle).

The accounting concept of

depreciation involves the

systematic and rational allocation of a long-lived asset’s cost to the multiple periods it is used to

generate revenue(matching principle).

This is a “cost allocation” concept,

not a “valuation” concept.


4-30

Recording Depreciation

The required journal entry requires a debit to Depreciation expense and a credit to an

account called Accumulated depreciation.

The required journal entry requires a debit to Depreciation expense and a credit to an

account called Accumulated depreciation.

As discussed earlier, this is called a Contra-Asset account.

As discussed earlier, this is called a Contra-Asset account.


4-31

Depreciation - Example 1

At January 31, 2001, Papa John’s trial balance showed Property & equipment of $338,000 (all numbers in

thousands) and Accumulated depreciation of $83,000. For the period, Papa John’s needs to record an

additional $2,500 in depreciation.

At January 31, 2001, Papa John’s trial balance showed Property & equipment of $338,000 (all numbers in

thousands) and Accumulated depreciation of $83,000. For the period, Papa John’s needs to record an

additional $2,500 in depreciation.


4-32

Depreciation - Example 1


Note: the expense is for the current month only


Note: the expense is for the current month only

1/31 2,500

Bal. 85,500

Accumulated Depreciation (BS)

Depreciation Expense (IS)

1/31 2,500

Bal. 2,500

1/31 83,000


4-33

The Closing Process

The following accounts are called temporary temporary or nominal accounts and are closed at the

end of the period . . .

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

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


4-34

Assets, liabilities, and stockholders’ equity are permanent, or real accounts, and are never

closed.

Assets, liabilities, and stockholders’ equity are permanent, or real accounts, and are never

closed.

AssetsLiabilitiesStockholders’

Equity

AssetsLiabilitiesStockholders’

Equity

The Closing Process


4-35

Two steps are used in the closing process

. . .1. Close revenues

and gains to Retained Earnings.

2. Close expenses and losses to Retained Earnings.

How to

Close

the

Books!

The Closing Process


4-36

To close Papa John’s Restaurant Sales Revenue account, the following entry is required:

To close Papa John’s Restaurant Sales Revenue account, the following entry is required:

The Closing Process


4-37

If we close the other revenue

accounts in a similar

fashion, the

retained earnings account

looks like this . . .

The Closing Process


4-38

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

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

The Closing Process


4-39

If we close the other expense

accounts in a similar

fashion, the retained earnings account

looks like this . . .

The Closing Process


4-40

Finally, we close

dividends to Retained

Earnings and the account balances out to $169,241

and looks like this . . .

The Closing Process


4-41

The Closing Entry

Normally, an entry is made similar to the one on page 180 with just a single entry, profit or loss, to Retained Earnings

All that is left is the Balance Sheet. See Papa John’s Post-closing TB, p. 181

Walk through the demonstration case on pages 181-188 prior to attempting the homework.


4-42

Financial Statement Preparation

The final step in the accounting cycle is to prepare the financial statements. . .Income statement,Statement of stockholders’ equity,Balance sheet, andStatement of cash flows.

The final step in the accounting cycle is to prepare the financial statements. . .Income statement,Statement of stockholders’ equity,Balance sheet, andStatement of cash flows.


4-43

Financial Statement Relationships

CONTRIBUTED CAPITAL

RETAINED EARNINGS

ASSETS LIABILITIESSTOCKHOLDERS’

EQUITY = +Increase

REVENUES EXPENSES –NET INCOME =

Increase


4-44

Statement of Stockholders’ Equity

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


4-45

Key Ratio Analysis: Net Profit Margin

The 2000 net profit margin for Papa John’s is based on net income of $32,000,000 and on

sales of $945,000,000, giving them a net profit margin of 3.39%, v.s. 5.87% and 4.74% in prior two years; v.s. 2.2% Domino’s & 5.8% Tricon.

The 2000 net profit margin for Papa John’s is based on net income of $32,000,000 and on

sales of $945,000,000, giving them a net profit margin of 3.39%, v.s. 5.87% and 4.74% in prior two years; v.s. 2.2% Domino’s & 5.8% Tricon.


4-46

End of Chapter 4

4

chapter 4 adjustments, financial statements, and the quality of earnings 9/07/04

Documents

expense recognition

fiscal period

right period

current period

total credit account

total debit account

end of accounting period

credit balances