Adjustments, Financial Statements, and the Quality of Earnings

Chapter 04
As modified by Prof. Robert Duquette CPA, MBA
for GBUS 401

PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA

McGraw-Hill/Irwin
4-1

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Understanding the Business

Management is
responsible for
preparing . . .

Financial
Statements

High Quality =
Relevance +
Reliability

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. . . useful to
investors and
creditors.

Accounting Cycle
Start of Period
During
During the
the period:
period:
Analyze
Analyze transactions.
transactions.
Record
Record journal
journal entries.
entries.
Post
Post amounts
amounts to
to general
general
ledger.
ledger.

At
At the
the end
end of
of the
the period:
period:
Adjust
Adjust revenues
revenues and
and
expenses.
expenses.

4-3

Close
Close revenues,
revenues,
gains,
gains, expenses,
expenses,
and
and losses
losses to
to
Retained
Retained Earnings.
Earnings.

Prepare
Prepare financial
financial
statements.
statements.
Disseminate
Disseminate
statements
statements to
to
users.
users.

Unadjusted Trial Balance

A
A listing
listing of
of individual
individual accounts,
accounts, usually
usually

in
in financial
financial statement
statement order.
order.
Ending
Ending debit
debit or
or credit
credit balances
balances are
are
listed
listed in
in two
two separate
separate columns.
columns.
Total
Total debit
debit account
account balances
balances should
should
equal
equal total
total credit
credit account
account balances.
balances.

Why
Why would
would you
you expect
expect them
them to
to equal?
equal?
What
What could
could go
go wrong?
wrong?
4-4

Partial Trial Balance

4-5

Partial Trial Balance

4-6

Purpose of Adjustments
Revenues
Revenues are
are
recorded
recorded when
when
earned.
earned.

Expenses
Expenses are
are
recorded
recorded when
when
incurred.
incurred.

Matching Principle

4-7

Because
Because transactions
transactions occur
occur over
over time,
time, ADJUSTMENTS
ADJUSTMENTS are
are
required
required at
at the
the end
end of
of each
each fiscal
fiscal period
period to
to get
get the
the revenues
revenues
and
and expenses
expenses into
into the
the right
right period.
period.
The
The company
company systems
systems and
and bookkeeping
bookkeeping are
are not
not aware
aware of
of all
all
possible
possible legal
legal and
and economic
economic arrangements
arrangements that
that have
have been
been
made
made in
in the
the business.
business.

Types of Adjustments

4-8

Adjustment Process

4-9

Deferred or Unearned Revenue: (ie a liability

account when set up, which is when the upfront
cash was received for future services; liability is
reduced when the services are performed)
Papa
Papa Johns
Johns received
received cash
cash last
last period
period and
and recorded
recorded an
an increase
increase in
in
Cash
Cash and
and increase
increase in
in Unearned
Unearned Franchise
Franchise Fees,
Fees, aa liability,
liability, to
to
recognize
recognize the
the businesss
businesss obligation
obligation to
to provide
provide future
future services
services to
to
franchisees.
franchisees. During
During January,
January, Papa
Papa Johns
Johns performed
performed $1,100
$1,100 in
in
services
services for
for franchisees
franchisees who
who had
had previously
previously paid
paid fees.
fees.

4-10

Accrued Revenue: AR (ie an asset account when

set up, which is when the right to earnings was
established and revenue was recorded; to be
reduced when the cash is received)
Papa
Papa Johns
Johns franchisees
franchisees owe
owe Papa
Papa Johns
Johns $830
$830 in
in royalties
royalties for
for sales
sales
the
the franchisees
franchisees made
made in
in the
the last
last week
week of
of January.
January. The
The cash
cash will
will be
be
received
received in
in the
the future,
future, which
which is
is when
when the
the accrued
accrued revenue
revenue account
account
will
will be
be credited.
credited.

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Accrued Revenue: Interest (ie asset account

when set up, which is when the interest is earned
and revenue is recorded; to be reduced when the
interest is collected in cash)
Papa
Papa Johns
Johns loaned
loaned $3,000
$3,000 to
to franchisees
franchisees on
on December
December 31
31 (one
(one
month
month ago)
ago) at
at 66 percent
percent interest
interest per
per year
year with
with interest
interest to
to be
be
paid
paid at
at the
the end
end of
of each
each year.
year. There
There was
was also
also $8,000
$8,000 in
in notes
notes
receivable
receivable outstanding
outstanding all
all month
month from
from prior
prior loans.
loans. There
There are
are
two
two components
components when
when lending
lending or
or borrowing
borrowing money:
money: principal
principal
(the
(the amount
amount loaned
loaned or
or borrowed)
borrowed) and
and interest
interest (the
(the cost
cost of
of
borrowing).
borrowing). Notes
Notes Receivable
Receivable (the
(the principal)
principal) was
was recorded
recorded
properly
properly when
when the
the money
money was
was loaned.
loaned.

4-12

Accrued Revenue: Interest (ie asset account

when set up, which is when the interest is earned
and revenue is recorded; to be reduced when the
interest is collected in cash)

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Deferred or Prepaid Expenses: Insurance and

Rent (ie asset accounts when set up, which is
when the insurance or rent is paid; to be reduced as
the insurance or leased space is consumed and
expensed)

Prepaid
Prepaid Expenses
Expenses includes
includes $2,000
$2,000 paid
paid on
on January
January 11 for
for
insurance
insurance coverage
coverage for
for four
four months
months (January
(January through
through April)
April)
and
and $6,000
$6,000 paid
paid on
on January
January 11 for
for rental
rental of
of space
space at
at shopping
shopping
centers
centers over
over three
three months
months (January
(January through
through March).
March).

4-14

Deferred or Prepaid Expenses: Insurance and

Rent (ie asset accounts when set up, which is
when the insurance or rent is paid; to be reduced
as the insurance or leased space is consumed
and expensed)

4-15

Deferred or Prepaid Expenses: Supplies (ie

asset account when set up, which is when the
supplies are purchased with cash or AP; to be
reduced as the supplies are consumed and
expensed)

Supplies
Supplies include
include food
food and
and paper
paper products.
products. At
At the
the end
end of
of the
the
month,
month, Papa
Papa Johns
Johns counted
counted $12,000
$12,000 in
in supplies
supplies on
on hand,
hand,
but
but the
the Supplies
Supplies account
account indicated
indicated aa balance
balance of
of $16,000.
$16,000. We
We
need
need to
to determine
determine the
the supplies
supplies used
used during
during the
the current
current
accounting
accounting period.
period.

4-16

Deferred or Prepaid Expenses: Supplies (ie asset

account when set up, which is when the supplies are
purchased with cash or AP; to be reduced as the
supplies are consumed and expensed)

4-17

Deferred or Prepaid Expenses: Property (ie

asset account when set up, which is when the
property is purchased with cash or AP; to be
reduced indirectly through a contra asset account
called Accumulated or Allowance for Depreciation
and Depreciation expense recorded)
Property
Property and
and equipment
equipment are
are assets
assets that
that have
have aa normal
normal debit
debit balance.
balance.
Depreciation
Depreciation is
is the
the allocation
allocation of
of the
the cost
cost of
of an
an asset
asset over
over its
its estimated
estimated
useful
useful life
life to
to the
the company.
company. Depreciation
Depreciation is
is an
an expense
expense with
with aa normal
normal debit
debit
balance.
balance. When
When we
we record
record depreciation
depreciation we
we credit
credit aa contra
contra asset
asset account
account
called
called Accumulated
Accumulated Depreciation.
Depreciation. Contra-accounts
Contra-accounts are
are accounts
accounts that
that are
are
directly
directly linked
linked to
to another
another account,
account, but
but with
with an
an opposite
opposite balance.
balance. We
We
subtract
subtract accumulated
accumulated depreciation
depreciation from
from the
the cost
cost of
of our
our property
property and
and
equipment
equipment to
to arrive
arrive at
at net
net book
book value.
value.

4-18

Deferred or Prepaid Expenses: Property (ie

asset account when set up, which is when the
property is purchased with cash or AP; to be
reduced indirectly through a contra asset account
called Accumulated or Allowance for Depreciation
and Depreciation expense recorded)
Papa
Papa Johns
Johns estimates
estimates depreciation
depreciation to
to be
be $30,000
$30,000 per
per year.
year.
$30,000
$30,000 12
12 months
months == $2,500
$2,500 per
per month
month depreciation
depreciation expense
expense

4-19

Accrued Expenses: Salaries, Utilities, and

Interest (i.e liabilities when set up, which is when
the expense is incurred but not yet paid; to be
reduced later when the liability is paid)
Papa
Papa Johns
Johns owed
owed (1)
(1) its
its employees
employees salaries
salaries for
for working
working four
four
days
days at
at the
the end
end of
of January
January at
at $500
$500 per
per day,
day, (2)
(2) $610
$610 for
for
utilities
utilities used
used in
in January,
January, and
and (3)
(3) interest
interest on
on its
its long-term
long-term
notes
notes payable
payable of
of $138,000
$138,000 borrowed
borrowed at
at aa 66 percent
percent annual
annual
rate.
rate.

Amounts for Accrued Expenses:

1. Salaries = $500 per day 4 days = $2,000
2. Utilities = $610
3. Interest = $138,000 .06 1/12 = $690
4-20

Accrued Expenses: Salaries, Utilities, and

Interest (i.e liabilities when set up, which is when
the expense is incurred but not yet paid; to be
reduced later when the liability is paid)

4-21

Accrued Expenses: Income Taxes (i.e liability

when set up, which is when the tax expense is
incurred but not yet paid; to be reduced later when
the liability is paid)
The final adjusting journal entry is to record the accrual of
income taxes that will be paid in the next quarter. This
requires computing adjusted pretax income (that is, balances
from the unadjusted trial balance plus the effects of all of the
other adjustments):
From
From our
our unadjusted
unadjusted trial
trial
balance
balance shown
shown earlier.
earlier.

4-22

Accrued Expenses: Income Taxes (i.e liability

when set up, which is when the tax expense is
incurred but not yet paid; to be reduced later when
the liability is paid)
Papa
Papa Johns
Johns average
average income
income tax
tax rate
rate is
is 34
34 percent.
percent. So,
So, the
the
estimated
estimated amount
amount of
of the
the taxes
taxes on
on this
this income
income that
that will
will be
be at
at
the
the end
end of
of the
the quarter
quarter is
is $11,500
$11,500 .34
.34 == $3,910.
$3,910.

4-23

Preparing Financial Statements

Before
Before we
we prepare
prepare aa complete
complete set
set of
of financial
financial
statements,
statements, lets
lets update
update the
the trial
trial balance
balance to
to
reflect
reflect the
the adjustments
adjustments and
and provide
provide us
us with
with
adjusted
adjusted balances
balances for
for the
the statements.
statements.
1.
1. Income
Income statement,
statement,
2.
2. Statement
Statement of
of stockholders
stockholders equity,
equity,
3.
3. Balance
Balance sheet,
sheet, and
and
4.
4. Statement
Statement of
of cash
cash flows.
flows.
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4-25

Financial Statement Relationships

4-26

Income Statement
This
This is
is the
the income
income statement
statement
drawn
drawn from
from the
the adjusted
adjusted trial
trial
balance.
balance. Refer
Refer back
back to
to the
the
adjusted
adjusted trial
trial balance
balance and
and trace
trace
the
the income
income statement
statement numbers
numbers
forward.
forward. Notice
Notice that
that gains
gains and
and
losses
losses are
are reported
reported in
in the
the Other
Other
Items
Items section
section of
of the
the statement.
statement.

4-27

Statement of Stockholders Equity

Net income appears on the statement of stockholders
equity as an increase in Retained Earnings.

From the income statement

Will
Will appear
appear on
on the
the balance
balance sheet
sheet
4-28

4-29

Closing the Books

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

4-30

Closing the Books

Here
Here is
is an
an example
example of
of the
the closing
closing process
process using
using an
an
illustration
illustration with
with just
just aa few
few accounts.
accounts.

4-31

Closing Entries for Papa Johns

Transfer
Transfer net
net income
income to
to Retained
Retained Earnings.
Earnings.

4-32

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 accounts will have a zero balance.

4-33

Key Ratio Analysis: 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

Net Income
Average Number of Common Shares Outstanding
during the Period

$7,590,000
$7,590,000 Net
Net Income
Income 28,1000,000
28,1000,000 Shares
Shares == $0.27
$0.27

4-34

Key Ratio Analysis: Net Profit Margin

Net
Net Profit
Profit Margin
Margin indicates
indicates how
how effective
effective
management
management is
is at
at generating
generating profit
profit on
on every
every
dollar
dollar of
of sales.
sales.
Net Profit
Margin

Net Income
Net Sales

Net profit margin for Papa Johns for 2008 is:

$36,796,000
$1,132,087,000
4-35

= .0325 = 3.25%

End of Chapter 04

4-36