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

McGraw-Hill/Irwin Slide 2 The Accounting Cycle During the Period (Chapters 2 and 3) Analyze transactions Record journal entries in the general journal Post amounts to the general ledger During the Period (Chapters 2 and 3) Analyze transactions Record journal entries in the general journal Post amounts to the general ledger Start of new period At the End of the Period (Chapter 4) Prepare a trial balance to determine if debits equal credits Adjust revenues and expenses and related balance sheet accounts (record in journal and post to ledger) Prepare a complete set of financial statements and disseminate it to users Close revenues, gains, expenses, and losses to Retained Earnings (record in journal and post to ledger) At the End of the Period (Chapter 4) Prepare a trial balance to determine if debits equal credits Adjust revenues and expenses and related balance sheet accounts (record in journal and post to ledger) Prepare a complete set of financial statements and disseminate it to users Close revenues, gains, expenses, and losses to Retained Earnings (record in journal and post to ledger)

Accounting Cycle-Another View l Prepare financial statements. l Disseminate statements to users. l Prepare financial statements. l Disseminate statements to users. l Close revenues, gains, expenses, and losses to Retained Earnings. 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. At the end of the period: l Adjust revenues and expenses. Start of Period

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/Irwin Slide 5 Note that total debits = total credits

McGraw-Hill/Irwin Slide 6 Purpose of Adjustments 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. Matching Principle

McGraw-Hill/Irwin Slide 7 Types of Adjustments There are four types of adjustments: (As discussed in Chapter 3)ExpensesExpenses 3.Prepaid Expenses. 4.Accrued Expenses. 3.Prepaid Expenses. 4.Accrued Expenses.RevenuesRevenues 1.Unearned Revenues. 2.Accrued Revenues. 1.Unearned Revenues. 2.Accrued Revenues.

 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 Accrued Expenses Involving Estimates

DEPRECIATION OF PLANT ASSETS  Plant assets are  Long-lived tangible assets, such as land, buildings, furniture, machinery, and equipment used in the operations of the business  Depreciation is  The process of allocating a portion of the cost of a plant asset (except land) to expense

McGraw-Hill/Irwin Slide 10 Accumulated depreciation is a contra-asset account. It is directly related to an asset account but has the opposite balance.

McGraw-Hill/Irwin Slide 11 Cost - Accumulated depreciation = BOOK VALUE.

McGraw-Hill/Irwin Slide 12 Preparing Financial Statements Before preparing a complete set of financial statements, we update the trial balance to reflect the adjustments and provide us with adjusted balances for the preparation of the statements: 1. Income statement, 2. Statement of stockholders’ equity, 3. Balance sheet, and 4. Statement of cash flows. Before preparing a complete set of financial statements, we update the trial balance to reflect the adjustments and provide us with adjusted balances for the preparation of the statements: 1. Income statement, 2. Statement of stockholders’ equity, 3. Balance sheet, and 4. Statement of cash flows.

McGraw-Hill/Irwin Slide Adjusted Trial Balance (through liabilities)

McGraw-Hill/Irwin Slide Adjusted Trial Balance (through stockholders’ equity and income)

McGraw-Hill/Irwin Slide 15 Income Statement This is the income statement drawn from the adjusted trial balance. Refer back to the adjusted trial balance and trace the income statement numbers forward. Notice that gains and losses are reported in the Other Items section of the statement. 4-15

McGraw-Hill/Irwin Slide 16 Earnings Per Share You will note that the earnings (EPS) ratio is reported on the income statement. It is widely used in evaluating the operating performance and profitability of a company. Earnings Per Share Earnings Per Share Net Income Average Number of Common Shares Outstanding** during the Period Net Income Average Number of Common Shares Outstanding** during the Period = = 4-16 **Outstanding shares are those that are currently held by the shareholders.

McGraw-Hill/Irwin Slide 17 Earnings Per Share 4-17

McGraw-Hill/Irwin Slide Balance Sheet (through total assets)

McGraw-Hill/Irwin Slide Balance Sheet (through total liabilities and stockholders’ equity)

McGraw-Hill/Irwin Slide 20 Statement of Stockholders’ Equity 4-20 The final total from the income statement, net income, is carried forward to the Retained Earnings column of the statement of stockholders’ equity. To this, the additional elements of the statement are added. Dividends declared and an additional stock issuance are also included in the statement:

McGraw-Hill/Irwin Slide 21 Focus on Cash Flows This statement is a categorized list of all transactions of the period that affected the Cash account. The three categories are Operating activities, 2. Investing activities, and 3. 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, 2. Investing activities, and 3. Financing activities.

McGraw-Hill/Irwin Slide 22 Focus on Cash Flows Disclosures 1.Cash interest paid. 2.Cash income taxes paid. 3.A schedule of significant noncash investing and financing 3.A schedule of significant noncash investing and financing transactions.Disclosures 1.Cash interest paid. 2.Cash income taxes paid. 3.A schedule of significant noncash investing and financing 3.A schedule of significant noncash investing and financing transactions.

McGraw-Hill/Irwin Slide 23 Closing the Books temporary The following accounts are called temporary or nominal accounts and are closed at the end of the period... Revenues. Revenues. Expenses. Expenses. Gains. Gains. Losses. Losses. Dividends declared. Dividends declared. Revenues. Revenues. Expenses. Expenses. Gains. Gains. Losses. Losses. Dividends declared. Dividends declared.

McGraw-Hill/Irwin Slide 24 Closing the Books Three steps are used in the closing process Close revenues and gains to Retained Earnings. 2. Close expenses and losses to Retained Earnings. 3. Close dividends to Retained Earnings.

McGraw-Hill/Irwin Slide 25 Here is an example of the closing process using an illustration with just a few accounts. Closing the Books

McGraw-Hill/Irwin Slide 26 Post-Closing Trial Balance After all temporary accounts have been closed, we prepare a post-closing trial balance. Only assets, liabilities, and stockholders’ equity accounts will appear. All revenue, expense, gain and loss and dividend accounts will have a zero balance.

McGraw-Hill/Irwin Slide 27 Total Asset Turnover Ratio The ratio helps us determine how efficient management is in using assets (its resources) to generate sales. 4-27

McGraw-Hill/Irwin Slide 28 Accruals and Deferrals: 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. 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.

© 2008 The McGraw-Hill Companies, Inc. End of Chapter 4