1. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Adjustments, Financial Statements, and the Quality of Earnings Chapter 4

2. 4-2 Business Background Management is responsible for preparing...... Are useful to investors and creditors. Financial Statements High Quality = Relevance + Reliability

3. 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 into the “right” period.

4. 4-4 Accounting Cycle 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.

5. 4-5 Learning Objectives Explain the purpose of a trial balance.

6. 4-6 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.

7. 4-7 Note that total debits = total credits

8. 4-8 Accumulated depreciation is a contra-asset account. It is directly related to an asset account but has the opposite balance.

9. 4-9 Cost - Accumulated depreciation = BOOK VALUE.

10. 4-10 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, or in copying ending balances from the ledger to the trial balance. or in copying ending balances from the ledger to the trial balance.

11. 4-11 Learning Objectives Analyze the adjustments necessary at the end of the period to update balance sheet and income statement accounts.

12. 4-12 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 or payments of cash in advance of revenue or expense recognition.

13. 4-13 End of accounting period. Cash received or paid. Revenues earned or expense incurred. Examples include interest earned during the period (accrued revenue) or wages earned by employees but not yet paid (accrued expense). Proper Recognition of Revenues and Expenses

14. 4-14 Recognizing Revenues in the Proper Period When cash is received prior to earning revenue by delivering goods or services, the company records a journal entry to recognize unearned revenue.

15. 4-15 End of accounting period. Cash received.Revenues earned. Example includes rent received in advance (an unearned revenue). Deferred Revenue

16. 4-16 Deferred Revenue On December 1, 2006, Tom’s Rentals received a check for $3,000, for the first four months’ rent from a new tenant. The entry on December 1, 2006, to record the receipt of the prepaid rent payment would be... On December 1, 2006, Tom’s Rentals received a check for $3,000, for the first four months’ rent from a new tenant. The entry on December 1, 2006, to record the receipt of the prepaid rent payment would be... This is a LIABILITY account

17. 4-17 Deferred Revenue 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 12/1/0612/31/06 Year end 2/28/071/31/073/31/07

18. 4-18 Deferred Revenue On December 31, 2006, Tom’s Rentals must adjust the Unearned Rent Revenue account to reflect that one month of rent revenue has been earned. $3,000 × 1/4 = $750 per month. On December 31, 2006, Tom’s Rentals must adjust the Unearned Rent Revenue account to reflect that one 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 time has decreased because they used the space for one month.

19. 4-19 Deferred Revenue After we post the entry to the T-accounts, the account balances look like this: Unearned Rent Revenue 12/31 75012/1 3000 Bal. 2,250 Rent Revenue 12/31 750 Bal. 750

20. 4-20 Accrued Revenues When revenues are earned but not yet recorded at the end of the accounting period because cash changes hands after the service is performed or goods delivered

21. 4-21 End of accounting period. Cash receivedRevenues earned Example includes interest earned during the period (accrued revenue). Accrued Revenue

22. 4-22 Accrued Revenue On October 1, 2006, 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, 2007. On December 31, 2006, Webb, Inc. must make an entry for the interest earned so far.

23. 4-23 Accrued Revenue After we post the entry to the T-accounts, the account balances look like this: Interest Receivable 12/31 150 Bal. 150 Interest Revenue 12/31 150 Bal. 150

24. 4-24 Chart for Deferred and Accrued Revenues

25. 4-25 Recognizing Expenses in the Proper Period When cash is paid prior to incurring an expense, the company records a journal entry to recognize an asset. An expense may be incurred in the current period but not paid until the next period. The company must recognize a liability.

26. 4-26 End of accounting period. Cash paid. Examples include prepaid rent, advertising, and insurance. Deferred Expense Expense incurred.

27. 4-27 Deferred Expense On January 1, 2006, 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. The entry on January 1, 2006, to record the policy on Matrix’s books would appear as follows... ASSET This is an ASSET account

28. 4-28 Deferred Expense At the end of 2006, 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 2006, 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. 1/1/0612/31/06 Year end 12/31/07 Year end 12/31/07 Year end Paid cash for insurance

29. 4-29 Deferred Expense On December 31, 2006, 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, 2006, 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▲.

30. 4-30 Deferred Expense 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 Remaining two years of insurance at $1,200 per year.

31. 4-31 Accrued Expenses Recall that accrued expenses are expenses incurred in the current period but not billed or paid until the next accounting period. Common examples are interest expense incurred on debt, wages expense owed to employees, and utilities expense. Recall that accrued expenses are expenses incurred in the current period but not billed or paid until the next accounting period. Common examples are interest expense incurred on debt, wages expense owed to employees, and utilities expense.

32. 4-32 Accrued Expenses As of 12/27/06, Denton, Inc. had already paid $1,900,000 in wages for the year. Denton pays its employees every Friday. Year-end, 12/31/06, falls on a Wednesday. The employees have earned total wages of $50,000 for Monday through Wednesday of the week ending 1/02/07.

33. 4-33 Accrued Expenses 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

34. 4-34 Chart for Deferred and Accrued Expenses

35. 4-35 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 $$$ Adjustments Involving Estimates

36. 4-36 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 Adjustments Involving Estimates Let’s look at the adjustment for depreciation expense.

37. 4-37 Depreciation Adjustment The accounting concept of depreciation involves the systematic and rational allocation of the cost of a long- lived asset over multiple accounting periods it is used to generate revenue. This is a “cost allocation” concept, not a “valuation” concept.

38. 4-38 Depreciation Adjustment The journal entry required is to debit Depreciation Expense and to credit an account called Accumulated Depreciation. This is called a Contra-Asset account.

39. 4-39 Depreciation Adjustment At January 1, 2004, Papa John’s trial balance showed Accumulated Depreciation of $149,000 (in thousands of dollars). For the month of January, Papa John’s needs to recognize $2,500 in depreciation.

40. 4-40 Depreciation Adjustment After we post the entry to the T-accounts, the account balances look like this (in thousands of dollars): 1/31 2,500 Bal. 151,500 Accumulated Depreciation Depreciation Expense 1/31 2,500 Bal. 2,500 1/1 149,000

41. 4-41 Learning Objectives Present an income statement with earnings per share, statement of stockholders’ equity, and balance sheet, and supplemental cash flow information.

42. 4-42 Financial Statement Preparation The next 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 next step in the accounting cycle is to prepare the financial statements...  Income statement,  Statement of stockholders’ equity,  Balance sheet, and  Statement of cash flows.

43. 4-43 The income statement is created first by determining the difference between revenues and expenses. Net income increases retained earnings (a net loss decreases retained earnings). Dividends decrease retained earnings. Financial Statement Relationships RETAINED EARNINGS REVENUESEXPENSES – NET INCOME = DIVIDENDS Decrease Increase

44. 4-44 STOCKHOLDERS’ EQUITY Financial Statement Relationships CONTRIBUTED CAPITAL RETAINED EARNINGS Contributed Capital and Retained Earnings make up Stockholders’ Equity. Increase REVENUESEXPENSES – NET INCOME = Increase

45. 4-45 Financial Statement Relationships CONTRIBUTED CAPITAL RETAINED EARNINGS ASSETSLIABILITIES STOCKHOLDERS’ EQUITY = + Increase REVENUESEXPENSES – NET INCOME = Increase

46. 4-46 The income statement contains revenues and expenses. Earnings Per Share (EPS) must be reported on the income statement.

47. 4-47 Statement of Stockholders’ Equity Net income appears on the statement of stockholders’ equity as an increase in Retained Earnings. From the Income Statement

48. 4-48 Balance Sheet - Assets $362,000 cost – $151,500 accumulated depreciation is equal to $210,500.

49. 4-49 Balance Sheet – Liabilities & Stockholders’ Equity From the statement of Stockholders’ Equity.

50. 4-50 Statement of Cash Flows This statement is a categorized list of all transactions of the period that affected the Cash account. The three categories are... 1. 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... 1. Operating activities, 2. Investing activities, and 3. Financing activities.

51. 4-51 Statement of Cash Flows

52. 4-52 Learning Objectives Compute and interpret the net profit margin.

53. 4-53 Key Ratio Analysis Net Profit Margin indicates how effective management is at generating profit on every dollar of sales. Net Income Net Sales Net Profit Margin = Net profit margin for January 2004 is: $7,241,000 $69,800,000 10.37% = 10.37%

54. 4-54 Learning Objectives Explain the closing process.

55. 4-55 Closing the Books Even though the balance sheet account balances carry forward from period to period, the income statement accounts do not. Closing entries: 1.Transfer net income (or loss) to Retained Earnings. 2.Establish a zero balance in each of the temporary accounts to start the next accounting period. Closing entries: 1.Transfer net income (or loss) to Retained Earnings. 2.Establish a zero balance in each of the temporary accounts to start the next accounting period.

56. 4-56 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.

57. 4-57 Closing the Books Assets, liabilities, and stockholders’ equity are permanent, or real accounts, and are never closed. Assets, liabilities, and stockholders’ equity are permanent, or real accounts, and are never closed. Assets. Assets. Liabilities. Liabilities. Stockholders’ Equity. Stockholders’ Equity. Assets. Assets. Liabilities. Liabilities. Stockholders’ Equity. Stockholders’ Equity.

58. 4-58 Closing the Books Two steps are used in the closing process... 1. Close revenues and gains to Retained Earnings. 2. Close expenses and losses to Retained Earnings. How to Close the Books!

59. 4-59 To close Papa John’s Restaurant Sales Revenue account, the following entry is required: Closing the Books

60. 4-60 Closing the Books If we close the other revenue accounts in a similar fashion, the retained earnings account looks like this...

61. 4-61 To close Papa John’s Cost of Sales - Restaurants account, the following entry is required: Closing the Books

62. 4-62 Closing the Books If we close the other expense accounts in a similar fashion, the retained earnings account looks like this...

63. 4-63 Closing the Books Assume that dividends declared are recognized in a separate dividend account, which is closed to Retained Earnings at the end of the period.

64. 4-64 Post-Closing Trial Balance Let’s take a look at the adjusted trial balance of Matrix, Inc. at December 31, 2004. We want to see the difference between the adjusted trial balance and the post-closing trial balance.

65. 4-65 Post-Closing Trial Balance Close these accounts. Net income is $1,200

66. 4-66 Post-Closing Trial Balance Retained earnings $2,960 ($1,760 + $1,200 net income).

67. 4-67 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.

68. 4-68 End of Chapter 4