Chapter 4: Adjustments, Financial

Statements, and Financial Results

Learning Objective 1

Explain why adjustments are

needed.

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 Why Adjustments Are Needed
Accounting systems are designed to record most
recurring daily transactions, particularly any
involving cash.

However, cash is not always received in the period in

which the company earns the related revenue;
likewise, cash is not always paid in the period in
which the company incurs the related expense.

Solution: Adjustments are made to the accounting records

at the end of the period to state assets, liabilities, revenues,
and expenses at appropriate amounts.
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 Why Adjustments Are Needed
Income Statement Balance Sheet
•Revenues are •Assets are reported at
recorded when amounts representing the
earned. economic benefits that
•Expenses are remain at the end of the
recorded in the same period.
period as the revenues •Liabilities are reported at
to which they relate. amounts owed at the end of
the period.
Adjustments help to ensure that all revenues and expenses are
reported in the period in which they are earned and incurred.
Without adjustments, the financial statements present an
incomplete and misleading picture of the company’s
financial performance.
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 1. Deferral Adjustments
An expense or revenue has been deferred if we have
postponed reporting it on the income statement until a
later period.

Sept. 1 Use-up rent Sept. 30

benefits

Cash paid for Adjustment

rent in advance needed

Deliver
Jan. 1 subscription Jan. 31
service

Cash received Adjustment

for subscription needed
in advance
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 1. Deferral Adjustments
Deferral adjustments are
Each deferral adjustment
used to decrease balance
involves one asset and
sheet accounts and
one expense account, or
increase corresponding
one liability and one
income statement
revenue account.
accounts.

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 2. Accrual Adjustments
Accrual adjustments are needed when a company has
earned revenue or incurred an expense in the current
period but has not yet recorded it because the related
cash will not be received or paid until a later period.
Sept. 1 Incur income Sept. 30 Dec. 31
taxes

Adjustment Cash paid for

needed income taxes

Jan. 1 Earn Jan. 31 Mar. 31

interest

Adjustment Cash received

needed for interest

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 2. Accrual Adjustments
Accrual adjustments are
used to record revenue Each accrual adjustment
or expenses when they involves one asset and
occur prior to receiving one revenue account, or
or paying cash, and to one liability and one
adjust corresponding expense account.
balance sheet accounts.

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 Learning Objective 2

Prepare adjustments needed at

the end of the period.

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 Making Required Adjustments

Adjustments are not made on a daily basis

because it’s more efficient to do them all at once
at the end of each period.

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 Adjustment Analysis, Recording and
Summarizing

1 Analyze
Determine the necessary adjustments to make to
the accounting records.

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4-11
 Deferral Adjustments
(a) Supplies Used during the Period.
Of the $1,600 in supplies received in early September, $400 remain on hand at
September 30.

1 Analyze
Assets = Liabilities + Stockholders' Equity
(a) Supplies -1,200 Supplies
Expense (+E) -1,200

2 Record
(a) dr Supplies Expense (+E, -SE) 1,200
cr Supplies (-A) 1,200

3 Summarize

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 Deferral Adjustments
(b) Rent Benefits Expired during the Period.
Three months of rent were prepaid on September 1 for $7,200, but one month has
now expired, leaving only two months prepaid at September 30.
1
/3 x $7,200 = $2,400
/3 x $7,200 = $4,800 asset
2
expense used up as of Sept.
remains prepaid as of Sept. 30
30

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 Deferral Adjustments
(b) Rent Benefits Expired during the Period.
Three months of rent were prepaid on September 1 for $7,200, but one month has
now expired, leaving only two months prepaid at September 30.

1 Analyze
Assets = Liabilities + Stockholders' Equity
(b) Prepaid Rent
Rent -2,400 Expense (+E) -2,400

2 Record
(b) dr Rent Expense (+E, -SE) 2,400
cr Prepaid Rent (-A) 2,400

3 Summarize

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 Deferral Adjustments
(c) Depreciation Is Recorded for Use of Equipment.
The restaurant equipment, which was estimated to last five years, has now been
used for one month, representing an estimated expense of $1,000.

Depreciation is the process of allocating the cost of

buildings, vehicles, and equipment to the accounting
periods in which they are used.

A contra-account
is an account that
is an offset to, or
reduction of,
another account.

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 Deferral Adjustments
(c) Depreciation Is Recorded for Use of Equipment.
The restaurant equipment, which was estimated to last five years, has now been
used for one month, representing an estimated expense of $1,000.
1 Analyze
Assets = Liabilities + Stockholders' Equity
(c) Accumulated Depreciation
Depr. +1,000 Expense (+E) +1,000

2 Record
(c) dr Depreciation Expense (+E, -SE) 1,000
cr Accumulated Depreciation (+xA, -A) 1,000

3 Summarize

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 Depreciation
Note 1 Note 2

Accumulated Depreciation Accumulated

Equipment
Depreciation Expense Depreciation

Total
Balance Income
Amount Original cost
Sheet Statement
Depreciated

Note 3 Note 4

Contra- Depreciation
Account Amount

Opposes
Depends on
account it
method used
offsets

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 Deferral Adjustments
(d) Gift Cards Redeemed for Service.
Pizza Aroma redeemed $160 of gift cards that customers used to pay for pizza.

1 Analyze
Assets = Liabilities + Stockholders' Equity
(d) Unearned Pizza
Revenue -160 Revenue (+R) +160

2 Record
(d) dr Unearned Revenue (-L) 160
cr Pizza Revenue (+R, +SE) 160

3 Summarize

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 Accrual Adjustments
(e) Revenues Earned but Not Yet Recorded.
Pizza Aroma provided $40 of Pizza to Mauricio’s close friend on the last day of
September, with payment to be received in October.

1 Analyze
Assets = Liabilities + Stockholders' Equity
(e) Accounts Pizza
Receivable +40 Revenue (+R) +40

2 Record
(e) dr Accounts Receivable (+A) 40
cr Pizza Revenue (+R, +SE) 40

3 Summarize

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 Accrual Adjustments
(f) Wages Expense Incurred but Not Yet
Recorded.
Pizza Aroma owes $900 of wages to employees for work done in the last three
days of September.

1 Analyze
Assets = Liabilities + Stockholders' Equity
(f) Wages Wages
Payable +900 Expense (+E) -900

2 Record
(f) dr Wages Expense (+E, -SE) 900
cr Wages Payable (+L) 900

3 Summarize

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 Accrual Adjustments
(g) Interest Expense Incurred but Not Yet Recorded.
Pizza Aroma has not paid or recorded the $100 interest that it owes for this month
on its note payable to the bank.

1 Analyze
Assets = Liabilities + Stockholders' Equity
(g) Interest Interest
Payable +100 Expense (+E) -100

2 Record
(g) dr Interest Expense (+E, -SE) 100
cr Interest Payable (+L) 100

3 Summarize

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 Accrual Adjustments
(h) Income Taxes Incurred but Not Yet Recorded.
Pizza Aroma pays income tax at an average rate equal to 40 percent of the
company’s income before taxes.

1 Analyze
Assets = Liabilities + Stockholders' Equity
(h) Income Tax Income Tax
Payable +400 Expense (+E) -400

2 Record
(h) dr Income Tax Expense (+E, -SE) 400
cr Income Tax Payable (+L) 400
$1,000 x 40% = $400
3 Summarize

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 Additional Comments

Adjusting entries always

Adjusting journal entries include one balance sheet
never involve cash. and one income statement
account.

Dividends are not

expenses. Instead, they are
a reduction of the retained
earnings.

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 Pizza Aroma’s Accounting Records
(i) Dividend Declared and Paid.
Pizza Aroma declares and pays a $500 cash dividend.

1 Analyze
Assets = Liabilities + Stockholders' Equity
(i) Cash -500 Dividends
Declared (+D) -500

2 Record
(i) dr Dividends Declared (+D, -SE) 500
cr Cash (-A) 500

3 Summarize

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 Learning Objective 3

Prepare an adjusted trial

balance.

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 PIZZA AROMA
Adjusted Trial Balance
As of September 30, 2010
Debit Credit
Cash $ 7,600
Partial Listing of T-accounts
Accounts Receivable 240
Supplies 400
Prepaid Rent 4,800
Cookware 630
Equipment 60,000
Accumulated Depreciation $ 1,000
Accounts Payable 1,030
Unearned Revenue 140
Wages Payable 900
Income Tax Payable 400
Interest Payable 100
Note Payable 20,000
Contributed Capital 50,000
Retained Earnings -
Dividends Declared 500
Pizza Revenue 15,700
Wages Expense 9,000
Rent Expense 2,400
Supplies Expense 1,200
Depreciation Expense 1,000
Utilities Expense 600
Advertising Expense 400
Interest Expense 100
Income Tax Expense 400
Total $ 89,270 $ 89,270

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 Learning Objective 4

Prepare financial statements.

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 PIZZA AROMA
Adjusted Trial Balance PIZZA AROMA, INC.
As of September 30, 2010 Income Statement
For the Month Ended September 30, 2010
Debit Credit
Revenues
Cash $ 7,600
Pizza Revenue $ 15,700
Accounts Receivable 240
Total Revenue 15,700
Supplies 400
Prepaid Rent 4,800 Expenses
Cookware 630 Wages Expense 9,000
Equipment 60,000 Rent Expense 2,400
Accumulated Depreciation $ 1,000 Supplies Expense 1,200
Accounts Payable 1,030 Depreciation Expense 1,000
Unearned Revenue 140 Utilities Expense 600
Wages Payable 900 Advertising Expense 400
Interest Expense 100
Income Tax Payable 400
Income Tax Expense 400
Interest Payable 100
Total Expenses 15,100
Note Payable 20,000
Net Income $ 600
Contributed Capital 50,000
Retained Earnings -
Dividends Declared 500
Pizza Revenue 15,700 PIZZA AROMA, INC.
Wages Expense 9,000 Statement of Retained Earnings
Rent Expense 2,400 For the Month Ended September 30, 2010
Supplies Expense 1,200
Retained Earnings, Sept. 1, 2010 $ -
Depreciation Expense 1,000
Add: Net Income 600
Utilities Expense 600
Subtract: Dividends Declared (500)
Advertising Expense 400
Retained Earnings, Sept. 30, 2010 $ 100
Interest Expense 100
Income Tax Expense 400
Total $ 89,270 $ 89,270

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 PIZZA AROMA PIZZA AROMA, INC.
Adjusted Trial Balance Balance Sheet
As of September 30, 2010 At September 30, 2010
Debit Credit Assets
Cash $ 7,600 Current Assets
Accounts Receivable 240 Cash $ 7,600
Supplies 400 Accounts Receivable 240
Prepaid Rent 4,800 Supplies 400
Cookware 630 Prepaid Rent 4,800
Equipment 60,000 Cookware 630
Accumulated Depreciation $ 1,000 Total Current Assets 13,670
Accounts Payable 1,030 Equipment $ 60,000
Unearned Revenue 140 Accumulated Depreciation (1,000) 59,000
Wages Payable 900 Total Assets $ 72,670
Income Tax Payable 400 Liabilities and Stockholders' Equity
Interest Payable 100 Liabilities
Note Payable 20,000 Current Liabilities
Contributed Capital 50,000 Accounts Payable $ 1,030
Retained Earnings - Unearned Revenue 140
Dividends Declared 500 Wages Payable 900
Pizza Revenue 15,700 Income Tax Payable 400
Wages Expense 9,000 Interest Payable 100
Rent Expense 2,400 Total Current Liabilities 2,570
Supplies Expense 1,200 Note Payable 20,000
Depreciation Expense 1,000 Total Liabilities 22,570
Utilities Expense 600
Stockholders' Equity
Advertising Expense 400
Contributed Capital 50,000
Interest Expense 100
Retained Earnings 100
Income Tax Expense 400
Total Stockholders' Equity 50,100
Total $ 89,270 $ 89,270
Total Liabilities and Stockholders' Equity $ 72,670

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 Learning Objective 5

Explain the closing process.

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 Closing Temporary Accounts

Transfer net income (or Establish zero balances

loss) and dividends to in all income statement
Retained Earnings. and dividend accounts.

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 Closing Temporary Accounts
Revenues Assets

Liabilities
Dividends
Expenses

Equity
Temporary Permanent
Accounts Accounts

Temporary
Temporaryaccounts
accounts Permanent
Permanentaccounts
accounts
track
trackfinancial
financial track
trackfinancial
financial
results
resultsfor
foraalimited
limited results
resultsfrom
fromyear
yearto
to
period
period ofof time.
time. year.
year.

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 Closing Temporary Accounts
Two closing journal entries are
needed.


Debit
DebitRevenue
Revenueaccounts
accountsand
and
credit
creditExpense
Expenseaccounts.
accounts. Debit
Debit
or
orcredit
creditthe
thedifference
differenceto
to
Retained
RetainedEarnings.
Earnings.


Credit
CreditDividends
DividendsDeclared
Declaredand
and
debit
debitRetained
RetainedEarnings.
Earnings.

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 PIZZA AROMA
Adjusted Trial Balance
As of September 30, 2010
Debit Credit
Cash $ 7,600
Accounts Receivable 240
Supplies 400 dr Pizza Revenue (-R) 15,700
Prepaid Rent 4,800 cr Wages Expense (-E) 9,000
Cookware 630 cr Rent Expense (-E) 2,400
Equipment 60,000
cr Supplies Expense (-E) 1,200
Accumulated Depreciation $ 1,000
Accounts Payable 1,030 cr Depreciation Expense (-E) 1,000
Unearned Revenue 140 cr Utilities Expense (-E) 600
Wages Payable 900 cr Advertising Expense (-E) 400
Income Tax Payable 400 cr Interest Expense (-E) 100
Interest Payable 100 cr Income Tax Expense (-E) 400
Note Payable 20,000 cr Retained Earnings (+SE) 600
Contributed Capital 50,000
Retained Earnings -
Dividends Declared 500
Pizza Revenue 15,700
Wages Expense 9,000 dr Retained Earnings (-SE) 500
Rent Expense 2,400 cr Dividends Declared (-D) 500
Supplies Expense 1,200
Depreciation Expense 1,000
Utilities Expense 600
Advertising Expense 400
Interest Expense 100
Income Tax Expense 400
Total $ 89,270 $ 89,270

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 Closing Temporary Accounts
dr Pizza Revenue (-R)
cr Wages Expense (-E)
15,700
9,000 After posting these
cr Rent Expense (-E)
cr Supplies Expense (-E)
2,400
1,200
closing entries, all
cr Depreciation Expense (-E)
cr Utilities Expense (-E)
1,000
600
the income
cr Advertising Expense (-E) 400 statement accounts
cr Interest Expense (-E) 100
cr Income Tax Expense (-E) 400 and the dividend
cr Retained Earnings (+SE) 600
account will have a
dr Retained Earnings (-SE) 500
cr Dividends Declared (-D) 500 zero balance.

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 Post-Closing Trial Balance
Final check that all
debits still equal
credits and that all
temporary accounts
have been closed.

Contains balances for

only permanent
accounts.

Is the last step in the

accounting process.

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