Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Chapter 4 Adjustments, Financial Statements, and the Quality of Financial Reporting

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Supercuts’ Situation Supercuts needs to update or adjust their financial information, such as the amount of supplies inventory on hand and interest owed on debt, to ensure the financial statements include the financial results of all the company’s activities for the period.

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Learning Objective 1 Explain why adjustments are needed.

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Why Adjustments Are Needed The solution for this timing difference is to record adjusting entries at the end of the period to get the amounts reported as revenues and expenses up to date. Accounting systems are designed to record most recurring daily transactions, particularly any involving cash. The problem is that cash is not always received or paid in the period when the revenue is earned or when the expense is incurred.

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Why Adjustments Are Needed For example, at the end of September, does Supercuts still have $7,200 of Prepaid Rent to use in the future? No, because Supercuts used 1 / 3 of the Prepaid Rent in September. During September, Supercuts incurred Rent Expense of $2,400. Supercuts needs to adjust or update the balances in both the Prepaid Rent account and the Rent Expense account.

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Assets Liabilities Expenses Revenues The accounts in a deferral adjustment always go in opposite directions. That is, a decrease in an asset goes with an increase in an expense, and a decrease in a liability goes with an increase in a revenue. Deferral adjustments are needed when: (a)some or all of an asset’s future benefits have expired or been used up in the current period, or (b)the company provides goods or services in the current period to satisfy an existing liability.

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin The accounts in an accrual adjustment always go in same direction. That is, an increase in an asset goes with an increase in a revenue, and an increase in a liability goes with an increase in an expense. Accrual adjustments are needed when: (a)assets and revenues are generated in the current period but haven’t been recorded as of the end of the period, or (b)liabilities and expenses are incurred in the current period but haven’t been recorded as of the end of the period. Assets Liabilities Expenses Revenues

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin The accounts in any adjustment always include one balance sheet account (an asset or liability) and one income statement account (revenue or expense). Assets Liabilities Expenses Revenues Expenses Revenues

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Learning Objective 2 Prepare adjustments needed at the end of the period.

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Making Required Adjustments

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Deferral Adjustments Remember this entry we made in Chapter 2 to record the receipt of hair supplies? During September, Supercuts used supplies but their use wasn’t recorded simply because it wasn’t efficient to record a journal entry each day when supplies were used. Let’s see how to record the necessary adjustment.

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Deferral Adjustments

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Deferral Adjustments

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Deferral Adjustments

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Deferral Adjustments Take a minute and look at this Unadjusted Trial Balance. In addition to Supplies, other assets we need to adjust include Prepaid Rent, Prepaid Insurance, and Equipment. First, let’s look at how to adjust the Prepaid Rent and Prepaid Insurance accounts.

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Deferral Adjustments Recall that the Prepaid Rent of $7,200 was for September, October, and November rent. So, during September, we used 1 / 3 of the rent, or $2,400. After posting this adjusting entry, the ledger accounts would look like this:

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Deferral Adjustments Recall that the Prepaid Insurance of $3,600 was for 12 months of insurance. So, during September, we used 1 / 12 of the insurance, or $300. After posting this adjusting entry, the ledger accounts would look like this:

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Deferral Adjustments Carrying value simply means the amount an asset or liability is reported at (“carried at”) in the financial statements. It is also known as “net book value” or simply “book value.” Deferral adjustments have two effects: Notice: 1)They reduce the carrying value of assets on the balance sheet, and 2)They transfer the amount of the reductions to related expense accounts.

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Deferral Adjustments—Depreciation Recording Depreciation Expense and Accumulated Depreciation Depreciation is the process of allocating the cost of property and equipment to the accounting periods in which they are used to generate revenues. A contra-account is an account that is an offset to, or reduction of, another account.

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Deferral Adjustments—Depreciation Your salon manager determined that depreciation on the equipment for this month should be $1,000. After posting this adjusting entry, the ledger accounts would look like this:

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Deferral Adjustments—Depreciation Depreciation  Market Value In accounting, depreciation is never intended to show a reduction in market value.

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Deferral Adjustments During September, stylists accepted $175 of gift certificates to pay for haircuts. After posting this adjusting entry, the ledger accounts would look like this:

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Accrual Adjustments On September 30, Supercuts provided $40 of haircut services to the salon manager, with payment to be received in October. Let’s see how to record the necessary adjustment.

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Accrual Adjustments

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Accrual Adjustments

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Accrual Adjustments

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Accrual Adjustments Supercuts owes $900 of wages to stylists for work done in the last three days of September. After posting this adjusting entry, the ledger accounts would look like this:

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Accrual Adjustments After posting this adjusting entry, the ledger accounts would look like this: Supercuts has not paid or recorded the $100 interest that it owes for this month on its note payable to the bank.

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Accrual Adjustments Supercuts pays income tax at an average rate equal to 40% of the salon’s income before taxes ($1,685). After posting this adjusting entry, the ledger accounts would look like this:

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Adjusting journal entries never involve cash Dividends are not expenses of the business. Final Comments

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Dividends Supercuts declares and pays a $500 cash dividend. After posting this adjusting entry, the ledger accounts would look like this:

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Learning Objective 3 Prepare an adjusted trial balance.

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin The adjusted trial balance is a list of all accounts and their adjusted balances to check on the equality of recorded debits and credits. Here is the adjusted trial balance for Supercuts. The amounts were taken from the balances in the ledger accounts after adjusting entries were made.

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Learning Objective 4 Prepare adjusted financial statements.

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Now let’s prepare the financial statements for Supercuts. Let’s prepare the financial statements in this order: 1.Income Statement 2.Statement of Retained Earnings 3.Balance Sheet

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Learning Objective 5 Explain the closing process.

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Closing Temporary Accounts Transfers net income (or loss) and dividends to Retained Earnings. Establishes zero balances in all income statement and dividend accounts.

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Temporary accounts track financial results for a limited period of time. Closing Temporary Accounts Revenues Expenses Dividends Temporary Accounts Permanent Accounts Assets Liabilities Equity Permanent accounts track financial results from year to year.

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Let’s prepare the closing entries for Supercuts! Recording Closing Entries  Debit Revenue accounts and credit Expense accounts. Debit or credit the difference to Retained Earnings.  Credit Dividends Declared and debit Retained Earnings.  Debit Revenue accounts and credit Expense accounts. Debit or credit the difference to Retained Earnings.  Credit Dividends Declared and debit Retained Earnings.

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin After posting these closing entries, all the income statement accounts and the dividend account will have a zero balance. Below is an example of how two accounts would look after posting the closing entries.

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Post-Closing Trial Balance Final check that all debits still equal credits and that all temporary accounts have been closed. Contains only permanent accounts. Is the last step in the accounting process.

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Learning Objective 6 Explain how adjustments affect information quality.

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Adjustments and Information Quality If a company bases its adjustments on honest but optimistic estimates that lead to a higher net income, most people will refer to the company as “aggressive” and its earnings as “lower quality”— having been influenced by management’s optimism about the future. Accounting research studies have found that, overall, adjustments significantly improve the quality of financial statements by ensuring that revenues are recognized when they are earned and expenses are recorded when incurred.

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin End of Chapter 4