Adjustments, Financial Statements, and the Quality of Earnings Chapter 4: Adjustments, financial statements, and the quality of earnings. Chapter 4 McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, Inc.

Accounting Cycle Prepare financial statements. Start of Period During the period: Analyze transactions. Record journal entries. Post amounts to general ledger. Close revenues, gains, expenses, and losses to Retained Earnings. 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 toward learning about adjusting entries. Prepare financial statements. Disseminate statements to users. At the end of the period: Adjust revenues and expenses.

There are four types of adjustments. Revenues Unearned Revenues. Accrued Revenues. Expenses Prepaid Expenses. Accrued Expenses. There are four types of adjustments. Unearned 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. The second type of adjustment is accrued revenues. Accrued revenues represent revenues that were earned but not recorded because cash was received after the services were performed or goods were delivered. Prepaid 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.

Example includes rent received in advance (an unearned revenue). Unearned Revenues End of accounting period. Cash received. Revenues earned. 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. Example includes rent received in advance (an unearned revenue).

Unearned Revenues $3,000 × 1/4 = $750 per month. On December 1, 2009, Tom’s Rentals received a check for $3,000, for the first four months’ rent from a new tenant. The adjustment on December 31, 2009, to reduce the liability and record the revenue earned would be: 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. On December 31st , it’s necessary to make an adjusting entry to recognize the revenue earned as a result of providing services to the 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 the revenue earned. $3,000 × 1/4 = $750 per month.

Unearned Revenues 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 The journal entry posted to posted to the 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, 2009. Any unearned rent revenue will appear as a liability on the balance sheet.

Example includes interest earned during the period (accrued revenue). End of accounting period. Revenues earned Cash received 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. Example includes interest earned during the period (accrued revenue).

Accrued Revenue At December 31st, Matrix, Inc. earned, but has not received, interest on its money market account of $150. The adjustment is made to debit Interest Receivable and credit Interest Revenue. At December 31st, Matrix, Inc. earned, but has not received, interest on its money market account of $150. The adjustment is made to debit, or increase, to Interest Receivable and credit, or increase to Interest Revenue. After posting the adjusting journal entry at December 31, the two T-accounts will each have a balance of $150. Interest Receivable 12/31 150 Bal. 150 Interest Revenue 12/31 150 Bal. 150

Examples include prepaid rent, advertising, and insurance. Prepaid Expenses End of accounting period. Cash paid. Expense incurred. A deferred expense is one in which cash is paid before the expense is recognized. Examples would include prepaid rent or prepaid advertising. Examples include prepaid rent, advertising, and insurance.

Prepaid Expenses $3,600 × 1/3 = $1,200 per year. On January 1, 2009, 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. At December 31st, Matrix must recognize the portion of the insurance that has been consumed and becomes an expense. On January 1, 2009, 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 the 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. The adjusting journal entry on December 31, 2009, 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 the expenses will go up by $1,200. $3,600 × 1/3 = $1,200 per year.

Remaining two years of insurance at $1,200 per year. Prepaid Expenses 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 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. Remaining two years of insurance at $1,200 per year.

Examples include accrued rent, accrued interest, and accrued wages. Accrued Expenses End of accounting period. Expense incurred. Expense paid. An accrued expense is one in which the expense is incurred in one accounting period but not paid until the following accounting period. Examples included accrued rent, accrued interest and accrued wages. Examples include accrued rent, accrued interest, and accrued wages.

Accrued Expenses As of 12/27/09, Denton, Inc. had already paid $1,900,000 in wages for the year. Denton pays its employees every Friday. Year-end, 12/31/09, falls on a Wednesday. The employees have earned total wages of $50,000 for Monday through Wednesday of the week ending 1/02/10. Part I On December 27, 2009, 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, 2009, 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, 2010. What adjusting journal entry do you think is necessary at December 31, 2009? Part II On December 31, 2009, Denton will debit wages expense for $50,000 and credit wages payable for the same amount. The expense must be recognized in the period in which it was incurred, even though it will not be paid until the next period.

Accrued Expenses After we post the entry to the T-accounts, the account balances look like this: Wages Expense $1,900,000 Bal. $1,950,000 As of 12/27 12/31 50,000 Wages Payable 12/31 50,000 Bal. 50,000 After we post the adjusting journal entry, the balance in wages expense will be $1,950,000. Of course, wages expense will appear on the current period income statement. Wages payable is a liability and will appear on the balance sheet.

Accrued Expenses Involving Estimates Certain circumstances require adjusting entries to record accounting estimates. Examples include . . . Depreciation Bad debts Income taxes 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.

Depreciation A systematic and rational method of allocating the cost of a fixed asset over its expected period of benefit. Method of matching the cost of using a long term asset to generate revenue in a given period.

Calculating Depreciation Cost of asset: $100,000 Salvage Value (what it will be worth at the end of its useful life): $-0- Useful Life: 5 years How much of the asset should be expensed each year?

Recording Depreciation Always Debit DEPRECIATION EXPENSE CREDIT: Accumulated Depreciation (a contra asset – nets against the cost of the asset) Cost of asset LESS Accumulated Depreciation equals BOOK VALUE of asset. Amount of Accumulated Depreciation accumulates over the useful life of the asset so that at the end of the assets useful life the Book Value is equal to the Salvage Value.

Book Value over Assets Life Year Depreciation Expense Asset Cost Accumulated Depreciation Book Value Year 1 $20,000 $100,000 $80,000 Year 2 $40,000 $60,000 Year 3 Year 4 Year 5 $-0-

Book Value over Assets Life Assume that the Asset Cost is Still $100,000, Useful life is still 5 years, but Salvage Value is now $25,000. Year Depreciation Expense Asset Cost Accumulated Depreciation Book Value Year 1 $15,000 $100,000 $85,000 Year 2 $30,000 $70,000 Year 3 $45,000 $55,000 Year 4 $60,000 $40,000 Year 5 $75,000 $25,000