Adjustments, Financial Statements, Accrual

Accounting, and the Quality of Earnings

Introduction to Accounting
NYUAD – Fall I – 2021
Anisa Shyti

1-1
 Recap of previous meeting
• Full Accounting Equation

• Conceptual Framework
– Objectives of Financial Statements
– Quality and Characteristics of Fin Info
– Definitions of Assets, Liabilities, SE, Dividends

• Business Transactions and Changes in Financial Statements

• Technicalities:
– Journal entries
– T-Accounts

• Recognition and Measurement: Revenues and Expenses

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 Objectives

• The Accounting Cycle – background on information disclosure

• Accrual Accounting – Principles

– Revenue Recognition
– Matching Expenses

• Unadjusted Trial Balance and Adjusting Entries

– Deferred Expenses and Revenues
– Accrued Expenses and Revenues

• Preparing Financial Statements

• Closing the Books Process

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 Understanding the Business

Management is
responsible for
preparing . . .

Financial
Statements

High Quality = . . . useful to

Relevance + investors and
Reliability creditors

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 The Accounting Cycle

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 The Income Statement

The Income Statement:

• Reports changes in shareholders’ equity due to operations

over a period of time

• Income statement equation:

• Net Income = Revenue – Expenses
• Net income is also called “earnings” or “net profit”

• All income statement items are based on Accrual Accounting

principles

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 Accrual Accounting

• Accounting recognition of revenues and expenses are tied to

business activities, not to cash flows

• Revenues are recognized when goods or services are

provided (revenue recognition criteria)
• => Revenues ≠ Cash inflows

• Expenses are recognized in the same period as the revenues

they helped to generate (matching principle)
• => Expenses ≠ Cash outflows

• => Net income ≠ Net cash flow

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 Revenues

Revenue is an increase in shareholders’ equity (not

necessarily cash) from providing goods and services

• Revenue is recognized when either:

– It is earned (i.e., goods or services are provided), and
– It is realized (i.e., payment for goods or services received in cash or
something that can be converted to a known amount of cash)

• These conditions are called revenue recognition criteria

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 Expenses

Expenses are decreases in shareholders’ equity (not

necessarily cash) that arise in the process of generating
revenues

• Expenses are recognized when either:

– Related revenues are recognized (product costs) or
– Incurred, if difficult to match with revenues (period costs and unusual events)

• The underlying recognition concepts are:

– Matching principle (product vs. period costs)
– Conservatism principle (unusual events): recognize anticipated losses
immediately, recognize anticipated gains only when realized

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 How Much Revenue Is Recognized in December? I

• Fast delivers $400,000 worth of washing machines in December to

customers who don’t have to pay until February

• $400,000

• Fast collects $500,000 cash in December for washing machines

delivered in October

• $0

• Fast RealE leases space to a tenant for the months of December and
January for $20,000, all of which is paid for in cash in December

• $10,000

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 How Much Revenue Is Recognized in December? II

• Fast receives an order for a $500,000 jet in December to be delivered in

July

• $0

• Fast is owed $180,000 of interest on a loan for December and receives

the payment in January

• $180,000

• Fast issues 40,000 shares of stock in December and receives $10/share,

which is $4/share more than they expected

• $0

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 How Much Expense Is Recognized in December? I

• Fast Automotive buys engines worth $1,000,000 in December for cash

• $0

• Fast Automotive uses the engines to make cars at a total cost of

$15,000,000 in December

• $0

• Fast Automotive sells cars costing $9,000,000 in December for

$16,000,000

• $9,000,000

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 How Much Expense Is Recognized in December? II

• Fast incurs $300,000 in salaries for its marketing staff in December

• $300,000

• Fast Automotive pays its auditor $100,000 in December for services to

be rendered in December and January

• $50,000

• Fast Automotive pays $2,200,000 in cash dividends in December

• $0

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 in December.
q. Phillips-Van Heusen Corporation, manufacturer of Izod, Arrow, Van Heusen, and Calvin Klein shirts,
completes production of 500 men’s shirts ordered by Macy’s department stores at a cost of $10 each
Exercise
and delivers the order. Answer from Phillips-Van Heusen’s standpoint.
Required:
For each of the transactions, if an expense is to be recognized in January, indicate the expense account
title and the amount. If an expense is not to be recognized in January, indicate why.

-5 Determining Financial Statement Effects of Various Transactions

O4 The following transactions occurred during a recent year:

a. Issued stock to organizers for cash (example). i. Earned revenue; collected three-fourths in cash,
b. Purchased equipment on credit. balance on credit.
c. Declared and paid cash dividends. j. Borrowed cash from local bank.
d. Earned revenue, collected cash. k. Collected cash from customers on account.
e. Incurred expenses, on credit. l. Experienced theft (a loss) of $100 cash.
f. Earned revenue, on credit. m. Incurred expenses; paid four-fifths in cash, bal-
g. Paid cash on account. ance on credit.
h. Incurred expenses; paid cash. n. Paid income tax expense for the period.

26/07

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 Exercise – cont’d
CHAPTER 3 Operating Decisions an

Required:
For each of the transactions, complete the tabulation, indicating the effect (+ for increase and – for
decrease) of each transaction. (Remember that A  = L  + SE, R  – E  = NI, and NI affects SE through
Retained Earnings.) Write NE if there is no effect. The first transaction is provided as an example.

BALANCE SHEET INCOME STATEMENT

Stockholders’
Transaction Assets Liabilities Equity Revenues Expenses Net Income

(a) (example) + NE + NE NE NE

Determining Financial Statement Effects of Various Transactions E3

Wolverine World Wide, Inc., manufactures military, work, sport, and casual footwear and leather acces- LO
sories under a variety of brand names, such as Hush Puppies, Wolverine, and Bates, to a global market.
Wo
The following transactions occurred during a recent year. Dollars are in thousands.
a. Issued common stock to investors for $7,047 cash (example).
1-15b. Purchased $765,472 of additional inventory on account.
c. Borrowed $59,500.
 Solution

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 Adjustments and Financial Statements

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 The Accounting Cycle
ccounting Cycle

Analyze
Transactions During Period

Journalize
and Post
End of Period

Unadjusted
Trial Balance

adjusted trial balance:

Account Account
balances are balances
summed are summed
on a worksheet to verify on
thatadebits
worksheet
equal credits
verify that debits equal credits

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 The Accounting Cycle
The Accounting Cycle

Analyze
Transactions During Period

Journalize
and Post
End of Period

Unadjusted
Trial Balance
Adjusting
Entries
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 debitKNOWLEDGE
accountFORbalances
ACTION
should equal total credit account balances

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 Adjusting entries
The solution to timing inconsistencies between cash, expenses, and
revenue -- record adjusting entries at the end of every accounting period:

1. Revenues are recorded when they are earned (the revenue realization
principle),
2. Expenses are recorded when they are incurred to generate revenue (the
expense matching principle),
3. Assets are reported at amounts that represent the probable future
benefits remaining at the end of the period, and
4. Liabilities are reported at amounts that represent the probable future
sacrifices of assets or services owed at the end of the period.

Companies wait until the end of the accounting period to adjust their
accounts (adjusting the records more frequently would be very costly and
time-consuming).

Adjusting entries are required every time a company wants to prepare

financial statements for external users.

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 Adjusting Entries

• Adjusting entries
• Internal transactions that update account balances in accordance with
accrual accounting prior to the preparation of financial statements

• Deferred Revenues and Expenses

• Update existing account balances to reflect current accounting
values
• Cash flow in past; record revenue/expense now

• Accrued Revenues and Expenses

• Create new account balances to reflect unrecorded assets or
liabilities
• Record revenue/expense now; cash flow in future

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 or paid and two in which cash will be received or paid). Each of these types of adjustments
involves two entries:
1. One for the cash receipt or payment.
Type of Adjustments
2. One for recording the revenue or expense in the proper period through the adjusting entry.

Period 1 End of Period 1 Period 2 EXH

Adjusting Entries that Increase Revenues:
Entry for cash
Deferred Revenues – Previously recorded liabilities that receipt
were created when cash was
received in advance, and that must Revenue
earned
be reduced for the amount of
revenue actually earned during Adjusting
the period. Entry

Adjusting Entry for cash

Accrued Revenues – Revenues that have been earned but receipt
Entry
not yet recorded because cash will
be received after the services are Revenue
performed or goods are delivered. earned

Adjusting Entries that Increase Expenses:

Deferred Expenses – Previously recorded assets, such as Entry for cash
Prepaid Rent, Supplies, and payment
Equipment, that were created when Expense
cash was paid in advance and that incurred
must be reduced for the amount of
expense actually incurred during the Adjusting
Entry
period through use of the asset.
Adjusting Entry for cash
Accrued Expenses – Expenses that have been incurred but Entry payment
not yet recorded because cash
will be paid after the goods or Expense
incurred
services are used.
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 Deferred Revenues

Question: Are there any liabilities, which have been

fulfilled by delivery of goods or services, that should be
recognized as revenue?
• Previously recorded liabilities, created when cash was received in
advance
• Must be reduced for the amount of revenue earned during the period

• Examples:
– Unearned rental revenue
– Deferred subscription revenue

• Journal Entry:

Dr. Unearned Revenue Liability (-L) XX

Cr. Revenue (+R, +SE) XX

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 Accrued Revenue

Question: Have any revenues accumulated during the

period that have not yet been recorded?
• Revenues that have been earned, but not yet recorded
• Cash will be received after services or goods are delivered

• Examples:
– Interest Receivable
– Rent Receivable

• Journal Entry:

Dr. Receivable Assets (+A) XX

Cr. Revenue (+R, +SE) XX

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 Deferred Expenses

Question: Are there any assets that have been “used up”
this period and should be expensed?
• Previously recorded asset, created when cash was paid in advance

• Must be reduced for the amount of expense incurred during the period

• Examples:
– Prepaid Rent
– Prepaid Insurance
– Depreciation or amortization

• Journal Entry:

Dr. Expense (+E, -SE) XX

Cr. Prepaid Asset (-A) XX

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 Accrued Expenses

Question: Have any expenses accumulated during the

period that have not yet been recorded?
• Expenses that have been incurred, but not yet recorded
• Cash will be paid after services or goods are used

• Examples:
– Income Taxes Payable
– Interest Payable
– Salaries and Wages Payable

• Journal Entry:

Dr. Expense (+E, -SE) XX

Cr. Payable Liability (+L) XX

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 Depreciation and Amortization

• Allocate the original cost of a long-lived asset over its

useful life:
• Matches the total cost of asset to the revenues it generates
• Relevant period: the asset’s period of use

• Terminology
• Tangible assets (physical assets) require depreciation
• Intangible assets (non-physical assets) require amortization

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 Depreciation and Amortization - II

• Accounting Procedure

• Depreciation is not deducted from the tangible asset account

• Rather, it is recorded in a Contra Asset Account (XA) called
Accumulated Depreciation, which:
• has a credit balance
• is subtracted from PP&E on the balance sheet to get the “Net Book Value”

• Amortization is often (but not always) deducted directly from the

intangible asset account

• Straight-line Depreciation:
– Depreciation expense = (Original Cost – Salvage Value) / Useful Life

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 What are the Journal Entries?

• September 30: Fast loans $100,000 to an employee at a 12% interest rate

Dr. Notes Receivable (+A) 100,000

Cr. Cash (-A) 100,000

• December 31: End of the fiscal year, and no principal or interest payments
have been made yet

Dr. Interest Receivable (+A) 3,000

Cr. Interest Revenue (+R, +SE) 3,000

• January 6: The employee sends a check for three months of interest on the
loan

Dr. Cash (+A) 3,000

Cr. Interest Receivable (-A) 3,000

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 What are the Journal Entries? II

• December 31: End of the fiscal year. During December, employees earned
$400,000 in salaries, but paychecks do not get issued until January 2

Dr. Salary Expense (+E, -SE) 400,000

Cr. Salaries Payable (+L) 400,000

• January 2: The paychecks are sent

Dr. Salaries Payable (-L) 400,000

Cr. Cash (-A) 400,000

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 What are the Journal Entries? III

• November 20: Fast pays $10,000 for December’s rent

Dr. Prepaid Rent (+A) 10,000

Cr. Cash (-A) 10,000

• December 31: End of the fiscal year. Is an adjusting entry needed? If so,
what is it?

Dr. Rent Expense (+E, -SE) 10,000

Cr. Prepaid Rent (-A) 10,000

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 What are the Journal Entries? IV

• June 30: A customer pays Fast $60,000 for a three-year software license

Dr. Cash (+A) 60,000

Cr. Unearned Software Revenues (+L) 60,000

• December 31: End of the fiscal year. Is an adjusting entry needed? If so,
what is it?

Dr. Unearned Software Revenues (-L) 10,000

Cr. Software revenue (+R, +SE) 10,000

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 What are the Journal Entries? V

• June 30: Fast purchases a building for $500,000. The expected life of the
building is 20 years and its expected salvage value is $100,000

Dr. Building (+A) 500,000

Cr. Cash (-A) 500,000

• December 31: End of the fiscal year. Is an adjusting entry needed? If so,
what is it?

Dr. Depreciation Expense (+E, -SE) 10,000

Cr. Accumulated Depreciation (+XA, -A) 10,000

(500,000 – 100,000) / 20 = 20,000 annual depreciation expense

20,000 / 2 = 10,000 six-month expense

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 What are the Journal Entries? VI

December 31: Fast has still an outstanding order for $500,000 of products that
will be delivered in January

No entry

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 Overview of Adjusting Entries
Overview of Adjusting Entries

Dr. Cash Dr. Liability Deferred Revenue

Cr. Liability Cr. Revenue

Dr. Asset Dr. Expense Deferred Expense

Cr. Cash Cr. Asset

Cash Accounting Cash

Transaction Recognition Transaction

Accrued Expense Dr. Expense Dr. Liability

Cr. Liability Cr. Cash

Accrued Revenue Dr. Asset Dr. Cash

Cr. Revenue Cr. Asset

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 Preparing Financial Statements

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 The Accounting Cycle - I
The Accounting Cycle

Analyze
Transactions During Period

Journalize
and Post
End of Period

Unadjusted
Trial Balance
Adjusting
Entries
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 debitKNOWLEDGE
accountFORbalances
ACTION
should equal total credit account balances

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 The Accounting Cycle - II
The Accounting Cycle

Analyze
Transactions During Period

Journalize
and Post
End of Period

Unadjusted
Trial Balance
Financial Adjusting
Statements Entries
Adjusted
Trial Balance

KNOWLEDGE FOR ACTION

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 Preparation of Financial Statements

• Adjusted Trial Balance

• Summarizes balances in each account after adjusting entries
• Used to make financial statements

• Preparation of Financial Statements – Steps:

① Prepare Income Statement first
② Use Net Income to update Retained Earnings and to prepare Balance
Sheet
③ Complete the Statement of Cash Flows and Statement of Stockholders’
Equity

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 Rev. Confirm

Relationship Among Statements

CHAPTER 4 Adjustments, Financial Statements, and the Quality of Earning

Another way of presenting the relationships among the statements is illustrated below. If a
number on the income statement changes, it will impact the other statements.

Income Statement Statement of Stockholders' Equity Balance Sheet

Contributed Capital + Retained Earnings = Total

Revenues Beginning balance Beginning balance Beginning balance Assets

– Expenses + Stock issuances + Stock issuances =
– Stock repurchases – Stock repurchases Liabilities
Net Income + Net income + Net income +
– Dividends – Dividends
Stockholders' Equity
Ending balance Ending balance Ending balance

Income Statement
The income statement is prepared first because net income is a component of Retained Earn-
ings. The January income statement for Papa John’s based on transactions in Chapters 2 and 3
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and adjustments in Chapter 4 follows.
 Income Statement Format

Income Statement Format

The general formatStatement
The Income of the Income statement
generally is the following:
has the following format:

Revenue (or Sales)

- Cost of Goods Sold
Gross Profit
- Operating (SG&A) Expense
Operating Income
- Interest, Gains, and Losses
Pre-tax Income
- Income Tax Expense
Net Income

1-41 KNOWLEDGE FOR ACTION

 The Balance Sheet Format: Assets

Generally assets are listed in the following order:

Ordered by
liquidity (how Current assets (benefits within the next year)
readily can they • Cash
be converted to
cash) • Accounts receivable
• Inventory
• Prepaid assets

Noncurrent assets
• Tangible assets
• Nontangible assets

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 The Balance Sheet Format: Liabilities and Stockholders’
Equity

Liabilities and Stockholders’ Equity are listed next in the following

order:

Ordered by
maturity (due Current liabilities (obligations within the next year)
dates) • Bank borrowings
• Accounts payable and other payables
• Deferred revenues

Noncurrent liabilities
• Bank borrowings and bonds
• Other types of liabilities (deferred taxes, pensions)

Stockholders’ equity
• Contributed capital
• Retained earnings

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 Income Statement

1-44 4-44
 Earnings Per Share

1-45 4-45
 Statement of Stockholders’ Equity

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:

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 Balance Sheet (A)

1-47 4-47
 Balance Sheet (L+SE)

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 The Accounting Cycle

The Accounting Cycle

Analyze
Start new period Transactions During Period

Journalize
Closing
and Post
Entries
End of Period

Unadjusted
Trial Balance
Financial Adjusting
Statements Entries
Adjusted
Trial Balance

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KNOWLEDGE FOR ACTION
 Type of Accounts

Temporary (or Nominal) Accounts

• Accumulate the effects of transactions for a period of time only
• Revenue and Expense accounts
• Closed out to retained earnings at the end of period

Permanent Accounts
• Accumulate the effects of transactions over the entire life of business
• Balance sheet accounts (Assets, Liabilities, Contributed Capital,
Retained Earnings)
• The only time these accounts have “zero” balance is when they are no
longer owned or owed

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 Closing the Books

Hence, 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.

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 Close Temporary Accounts

Closing entries
• Are internal transactions that "zero out" temporary accounts at the end of the
accounting period
• Revenue and Expense account balances are transferred to Retained Earnings

Revenues:
Dr. Revenue Accounts (-R, -SE)
Cr. Retained Earnings (+SE)
Expenses:
Dr. Retained Earnings (-SE)
Cr. Expense Accounts (-E, +SE)

Post-closing trial balance

• Summarizes balances of permanent accounts after closing entries
• All revenue and expense accounts have a zero balance

Now, we’re ready to start the next fiscal period

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