© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Chapter 4 The Adjustment Process and Financial Statements

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Business Background: The Accounting Cycle End of the Accounting Period Start of the Accounting Period l Perform transaction analysis. l Record journal entries. l Post amounts to general ledger. l Perform transaction analysis. l Record journal entries. l Post amounts to general ledger. Phase 1: During the Accounting Period. l Prepare a trial balance. l Analyze the account balances. l Record and post adjusting entries. l Prepare financial statements. l Record and post closing entries. l Prepare a trial balance. l Analyze the account balances. l Record and post adjusting entries. l Prepare financial statements. l Record and post closing entries. Phase 2: End of the Accounting Period.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Business Background As indicated in Phase 1 of the Accounting Cycle, external transactions between the business and other external parties are recorded during the period as they occur.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Business Background At the end of the accounting period, the account balances are analyzed and adjusting journal entries are recorded for internal transactions that have a direct and measurable effect on the accounting entity, particularly for revenue and expense recognition. End of Accounting Period Start of Accounting Period External Transactions Adjusting Entries Adjusting Entries

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson The 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. 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.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Note that total debits = total credits

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Accumulated amortization is a contra-asset account. It is directly related to an asset account but has a credit balance.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Cost - Accumulated amortization = BOOK VALUE.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson The Unadjusted Trial Balance do not If total debits do not equal total credits on the trial balance, errors have occurred... in preparing balanced journal entries. in preparing balanced journal entries. in posting the correct dollar effects of a transaction. in posting the correct dollar effects of a transaction. in copying ending balances from the ledger to the trial balance. in copying ending balances from the ledger to the trial balance.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Now that we have covered the trial balance, let’s discuss adjusting entries.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Adjusting Entries There are two types of adjusting entries. ACCRUALS Revenues earned or expenses incurred that have not been previously recorded. DEFERRALS Cash receipts or payments in advance of revenue or expense recognition.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson End of accounting period. Cash paidExpense incurred Example: insurance paid in advance. Deferrals

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Deferrals - Example 1 Our goal is to record the amount of insurance used up during Since the policy is for 3 years, we can assume that one third of the policy will expire each year. Our goal is to record the amount of insurance used up during Since the policy is for 3 years, we can assume that one third of the policy will expire each year. 1/1/0312/31/03 Year end 12/31/04 Year end 12/31/05 Year end Paid cash for insurance

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Deferrals - Example 1 On January 1, 2003, Tipton, Inc. paid $3,600 for a 3- year fire insurance policy. The entry on January 1, 2003, to record the policy on Tipton’s books would appear as follows... This is an ASSET account

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Deferrals - Example 1 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.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Deferrals - Example 1 After we post the entry to the T-accounts, the account balances look like this: Prepaid Insurance Expense 1/1 3,60012/31 1,200 Bal. 2,400 Insurance Expense 12/31 1,200 Bal. 1,200

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Deferrals Now, let’s look at an example of cash received in advance.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson End of accounting period. Cash receivedRevenues earned Example: rent received in advance. Deferrals

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Deferrals - Example 2 On December 1, 2003, Tom’s Rentals received a cheque for $3,000, for rent of an apartment for four months – December to March. The entry on December 1, 2003, to record the receipt of the rent received in advance would be... On December 1, 2003, Tom’s Rentals received a cheque for $3,000, for rent of an apartment for four months – December to March. The entry on December 1, 2003, to record the receipt of the rent received in advance would be... This is a LIABILITY account

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Deferrals - Example 2 Our goal is to 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. Our goal is to 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 12/1/0312/31/03 Year end 2/28/041/31/043/31/04

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Deferrals - Example 2 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.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Deferrals - Example 2 After we post the entry to the T-accounts, the account balances look like this: Unearned Rent Revenue 12/ / Bal. 2,250 Rent Revenue 12/ Bal. 750

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Accruals Now, let’s take a look at adjusting entries for accruals.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Accruals no cash Accruals occur when revenues have been earned or expenses incurred but no cash has been exchanged.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson End of accounting period. Cash receivedRevenues earned Example: interest earned during the period but not received until the next period. Accruals

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Accruals - Example 1 On October 1, 2003, Webb, Inc. invests $10,000 for 6 months in a certificate of deposit (CD) that pays 6% interest per year. Webb will not receive the interest until the CD matures on March 31, On December 31, 2003, Webb, Inc. must make an entry for the interest earned so far.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Accruals - Example 1 After we post the entry to the T-accounts, the account balances look like this: Interest Receivable 12/ Bal. 150 Interest Revenue 12/ Bal. 150

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson End of accounting period. Cash paidExpense incurred Example: wages earned by employees during this period but not paid until the next period. Accruals

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Accruals - Example 2 As of Dec. 27, 2003, Denton, Inc. had already paid $1,900,000 in wages for the year. Denton pays its employees every Friday. The year-end, Dec. 31, 2003, falls on a Wednesday. The employees have earned total wages of $50,000 for Monday, Dec. 29 through Wednesday, Dec. 31, 2003.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Accruals - Example 2 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

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Certain circumstances require adjusting entries to record accounting estimates. Examples include... l Amortization l Bad debts l Income taxes Certain circumstances require adjusting entries to record accounting estimates. Examples include... l Amortization l Bad debts l Income taxes $$$ Accounting Estimates

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Certain circumstances require adjusting entries to record accounting estimates. Examples include... l Amortization l Bad debts l Income taxes Certain circumstances require adjusting entries to record accounting estimates. Examples include... l Amortization l Bad debts l Income taxes Accounting Estimates Let’s look at how we handle amortization expense.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson amortization The accounting concept of amortization involves the systematic and rational allocation of a long-lived asset’s cost to the periods during which it is used to generate revenue. This is a “cost allocation” concept, not a “valuation” concept.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson amortization The required journal entry includes a debit to Amortization expense and a credit to an account called Accumulated amortization. As discussed earlier, this is called a Contra-Asset account.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Estimates - Example 1 At January 31, 2001, Papa John’s trial balance showed Property and equipment of $331,500 (all numbers in thousands) and Accumulated amortization of $83,400. For the period, Papa John’s needs to record an additional $2,600 in amortization.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Estimates - Example 1 After we post the entry to the T-accounts, the account balances look like this: 1/31 2,600 Bal. 86,000 Accumulated Amortization Amortization Expense 1/31 2,600 Bal. 2,600 12/31 83,400

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Financial Statement Preparation The next step in the accounting cycle is to prepare the financial statements... l Income statement, l Statement of retained earnings, l Balance sheet, and l Cash flow statement. The next step in the accounting cycle is to prepare the financial statements... l Income statement, l Statement of retained earnings, l Balance sheet, and l Cash flow statement.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson The income statement is created first by determining the difference between revenues and expenses. Net income increases retained earnings, while a net loss will decrease retained earnings. Dividends decrease retained earnings. Financial Statement Relationships RETAINED EARNINGS REVENUESEXPENSES – NET INCOME = DIVIDENDS Decrease Increases

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson SHAREHOLDERS’ EQUITY Financial Statement Relationships SHARE CAPITAL RETAINED EARNINGS REVENUESEXPENSES – NET INCOME = DIVIDENDS Share Capital and R/E make up Shareholders’ Equity. Increases

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Financial Statement Relationships SHARE CAPITAL RETAINED EARNINGS ASSETSLIABILITIES SHAREHOLDERS’ EQUITY = + REVENUESEXPENSES – NET INCOME = DIVIDENDS Increases

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Note that this statement has ONLY revenues and expenses! Earnings Per Share (EPS) must be reported on the income statement.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Income Statement EPS for Papa John’s is based on 24,703,000 shares outstanding and net income of $8,560,000.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Statement of Retained Earnings Net income appears on the statement of Retained Earnings as an increase to Retained Earnings.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Balance Sheet $331,500 cost - $86,000 accumulated amortization.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Balance Sheet - Continued Remember that Total liabilities and shareholders’ equity ($425,645) must equal Total assets ($425,645).

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Cash Flow Statement 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. 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.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Cash Flow Statement – General Model

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson   The Operating Activities section of Papa John’s Cash Flow Statement is prepared using the direct method, though most companies use the indirect method. We will take a more detailed look at this statement in Chapter 13.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Key Ratio Analysis: Net Profit Margin Net Profit Margin gives an indication of how effective management is at generating profit on every dollar of sales.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Key Ratio Analysis: Net Profit Margin From the 2001 income statement, Papa John’s had net income of $31,824,000 on sales of $944,677,000, giving them a net profit margin of 3.369%

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson 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. 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. The Closing Process

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson The Closing Process temporary The following accounts are called 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

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Assets, liabilities, and shareholders’ equity accounts are permanent, or real accounts, and are never closed. Assets Liabilities Shareholders’ Equity Assets Liabilities Shareholders’ Equity The Closing Process

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Two steps are used in the closing process... Ê Close revenues and gains to Retained Earnings. Ë Close expenses and losses to Retained Earnings. How to Close the Books! The Closing Process

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson To close Papa John’s Restaurant Sales Revenue account, the following entry is required: The Closing Process

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson If we close the other revenue accounts in a similar fashion, the retained earnings account looks like this... The Closing Process

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson To close Papa John’s Cost of Sales - Restaurants account, the following entry is required: The Closing Process

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson If we close the other expense accounts in a similar fashion, the retained earnings account looks like this... The Closing Process

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Finally, we close dividends to Retained Earnings and the account balances out to $174,360 and looks like this... The Closing Process

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson End of Chapter 4 4