Chapter 4 Adjustments, Financial Statements, and the Quality of Earnings 9/07/04

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 4-2 Business Background Management is responsible for preparing Are useful to investors and creditors. Financial Statements High Quality = Important, Timely and Reliable Info

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 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 in the “right” period.

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 4-4 Accounting Cycle During the period: l Analyze transactions. l Record journal entries. l Post amounts to general ledger. During the period: l Analyze transactions. l Record journal entries. l Post amounts to general ledger. At the end of the period: l Adjust revenues and expenses (matching) within the period. At the end of the period: l Adjust revenues and expenses (matching) within the period. l Close Books, i.e. revenues, gains, expenses, and losses to Retained Earnings l Prepare Financial Statements l Disseminate statements to users l Prepare Financial Statements l Disseminate statements to users

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 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!)

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 4-6 Note that total debits = total credits

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 4-7 Accumulated depreciation is a contra-asset account. It is directly related to an asset account but has the opposite balance.

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 4-8 Cost - Accumulated depreciation = BOOK VALUE.

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 4-9 Now that we have covered the trial balance, let’s discuss adjusting entries.

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 4-10 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 (cash) or payments of cash made in advance of revenue or expense recognition.

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 4-11 End of accounting period. Cash is received or paid in current period. Revenues earned or expense incurred in subsequent period Examples include rent received in advance (an unearned revenue) or insurance paid in advance (a prepaid expense). Deferrals (of revenue or expense recognition)

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 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... ASSET This is an ASSET account

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 4-13 Prepaid Expense - Example 1 At the end of 2003, 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. At the end of 2003, 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. 1/1/0312/31/03 Year end 12/31/04 Year end 12/31/05 Year end Paid cash for insurance

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 4-14 Prepaid Expense - 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. In effect, the prepaid asset goes down, while the expense goes up.

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 4-15 Prepaid Expense - Example 1 After we post the entry to the T-accounts, the account balances look like this: Prepaid Insurance (Balance sheet) 1/1 3,60012/31 1,200 Bal. 2,400 (IncomeStatement) 12/31 1,200 Bal. 1,200 Insurance Expense

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 4-16 Deferrals Now, let’s look at an example of cash received in advance.

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 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 account

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 4-18 Unearned Revenue - Example 2 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. 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 12/1/0312/31/03 Year end 2/28/041/31/043/31/04

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 4-19 Unearned Revenue - 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. In effect, our obligation to let them occupy the space for a period of has decreased, because they used the space for 1 month.

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 4-20 Unearned Revenue - Example 2 After we post the entry to the T-accounts, the account balances look like this: Unearned Rent Revenue (BS) 12/ / Bal. 2,250 Rent Revenue (IS) 12/ Bal. 750

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 4-21 Accruals (recognizing revenue and expense) Now, we need to look at adjusting entries for accruals.

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 4-22 Accruals no cash Accruals occur when revenues have been earned or expenses incurred but no cash has been exchanged or receivables or payables set up.

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 4-23 End of accounting period. Cash received or paid in subsequent period. Revenues earned or 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). Accruals

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 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, On December 31, 2003, Webb, Inc. must make an entry for the interest earned so far.

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 4-25 Accrued Revenue - Example 1 After we post the entry to the T-accounts, the account balances look like this: Interest Receivable (BS) 12/ Bal. 150 Interest Revenue (IS) 12/ Bal. 150

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 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.

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 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

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 4-28 Certain circumstances require adjusting entries to record accounting estimates. Examples include... Depreciation Bad debts Income taxes Certain circumstances require adjusting entries to record accounting estimates. Examples include... Depreciation Bad debts Income taxes $$$ Accounting Estimates

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 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.

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 4-30 Recording 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.

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 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.

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 4-32 Depreciation - Example 1 After we post the entry to the T-accounts, the account balances look like this: Note: the expense is for the current month only After we post the entry to the T-accounts, the account balances look like this: 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

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 4-33 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.

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 4-34 Assets, liabilities, and stockholders’ equity are permanent, or real accounts, and are never closed. Assets Liabilities Stockholders’ Equity Assets Liabilities Stockholders’ Equity The Closing Process

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 4-35 Two steps are used in the closing process Close revenues and gains to Retained Earnings. 2. Close expenses and losses to Retained Earnings. How to Close the Books! The Closing Process

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 4-36 To close Papa John’s Restaurant Sales Revenue account, the following entry is required: The Closing Process

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 4-37 If we close the other revenue accounts in a similar fashion, the retained earnings account looks like this... The Closing Process

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 4-38 To close Papa John’s Cost of Sales - Restaurants account, the following entry is required: The Closing Process

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 4-39 If we close the other expense accounts in a similar fashion, the retained earnings account looks like this... The Closing Process

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 4-40 Finally, we close dividends to Retained Earnings and the account balances out to $169,241 and looks like this... The Closing Process

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 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 prior to attempting the homework.

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 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, and Statement of cash flows. The final step in the accounting cycle is to prepare the financial statements... Income statement, Statement of stockholders’ equity, Balance sheet, and Statement of cash flows.

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 4-43 Financial Statement Relationships CONTRIBUTED CAPITAL RETAINED EARNINGS ASSETSLIABILITIES STOCKHOLDERS’ EQUITY = + Increase REVENUESEXPENSES – NET INCOME = Increase

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 4-44 Statement of Stockholders’ Equity Net income appears on the statement of stockholders’ equity as an increase in Retained Earnings.

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 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.

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 4-46 End of Chapter 4 4