Adjustments, Financial Statements, and the
Quality of Earnings
Chapter 4
McGraw-Hill/Irwin
© 2009 The McGraw-Hill Companies, Inc.
The Accounting Cycle
Start of new period
During the Period
(Chapters 2 and 3)
•Analyze transactions
•Record journal entries in the general journal
•Post amounts to the general ledger
At the End of the Period
(Chapter 4)
•Prepare a trial balance to determine if debits equal credits
•Adjust revenues and expenses and related balance sheet
accounts (record in journal and post to ledger)
•Prepare a complete set of financial statements and disseminate it
to users
•Close revenues, gains, expenses, and losses to Retained Earnings
(record in journal and post to ledger)
McGraw-Hill/Irwin
Slide 2
Accounting Cycle-Another View
Start of Period
During the period:
 Analyze transactions.
 Record journal entries.
 Post amounts to general
ledger.


At the end of the period:
 Adjust revenues and
expenses.

Close revenues,
gains, expenses, and
losses to Retained
Earnings.
Prepare financial
statements.
Disseminate
statements to
users.
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.
At December 31, 2012
Description
Cash
$
Accounts receivable
Inventory
Equipment
Accumulated depreciation - equip.
Furniture and fixtures
Accumulated depreciation - furn. & fix.
Accounts payable
Notes payable
Common stock
Retained earnings, 12/31/09
Note that
Sales revenue
total debits =
Cost of goods sold
total credits
Operating expenses
Totals
$
McGraw-Hill/Irwin
Debit
Credit
3,900
4,985
3,300
4,800
$
1,440
6,600
2,200
2,985
4,000
10,000
1,760
35,000
27,500
6,300
57,385 $
57,385
Slide 5
Purpose of Adjustments
Revenues are
recorded when
earned.
Expenses are
recorded when
incurred.
Matching Principle
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.
McGraw-Hill/Irwin
Slide 6
Types of Adjustments
There are four types of adjustments:
Revenues
1. Unearned
Revenues.
Expenses
3. Prepaid
Expenses.
2. Accrued
Revenues.
4. Accrued
Expenses.
(As discussed in Chapter 3)
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Slide 7
Unearned Revenues
End of
accounting period.
Cash received
Revenues earned
Example includes rent received in
advance (an unearned revenue).
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Slide 8
Accrued Revenue
End of
accounting period.
Revenues earned
Cash received
Example includes interest earned
during the period (accrued revenue).
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Slide 9
Prepaid Expenses
End of
accounting period.
Cash paid
Expense incurred
Examples include prepaid rent,
advertising, and insurance.
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Slide 10
Accrued Expenses
End of
accounting period.
Expense incurred
Expense paid
Examples include accrued rent,
accrued interest, and accrued wages.
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Slide 11
Accrued Expenses Involving Estimates
 Certain circumstances require
adjusting entries to record accounting
estimates.
 Examples include . . .
 Depreciation
 Bad
debts
 Income taxes

DEPRECIATION OF
PLANT ASSETS
Plant assets are


Long-lived tangible assets, such as land, buildings, furniture,
machinery, and equipment used in the operations of the
business
Depreciation is

The process of allocating a portion of the cost of a plant asset
(except land) to expense
Matrix, Inc.
Unadjusted Trial Balance
At December 31, 2010
Description
Debit
Credit
Cash
$
3,900
Accounts receivable
4,985
Inventory
3,300
Equipment
4,800
Accumulated depreciation - equip.
$
1,440
Furniture and fixtures
6,600
Accumulated depreciation - furn. & fix.
2,200
Accounts payable
2,985
Notes payable
Accumulated depreciation 4,000
Common stock
10,000
is
a
contra-asset
account.
Retained earnings, 12/31/09
1,760
It is directly related to an 35,000
Sales revenue
Cost of goods sold
asset account 27,500
but has the
Operating expenses
6,300
opposite balance.
Totals
McGraw-Hill/Irwin
$
57,385 $
57,385
Slide 14
Matrix, Inc.
Unadjusted Trial Balance
At December 31, 2010
Description
Debit
Cash
$
Accounts receivable
Inventory
Equipment
Accumulated depreciation - equip.
Furniture and fixtures
Accumulated depreciation - furn. & fix.
Cost - Accumulated depreciation =
Accounts payable
Notes payable BOOK VALUE.
Common stock
Retained earnings, 12/31/08
Sales revenue
Cost of goods sold
Operating expenses
Totals
McGraw-Hill/Irwin
$
Credit
3,900
4,985
3,300
4,800
$
1,440
6,600
2,200
2,985
4,000
10,000
1,760
35,000
27,500
6,300
57,385 $
57,385
Slide 15
Preparing Financial Statements
Before preparing a complete set of financial
statements, we update the trial balance to reflect
the adjustments and provide us with adjusted
balances for the preparation of the statements:
1. Income statement,
2. Statement of stockholders’ equity,
3. Balance sheet, and
4. Statement of cash flows.
McGraw-Hill/Irwin
Slide 16
Income Statement
This is the income statement
drawn from the adjusted trial
balance. Refer back to the
adjusted trial balance and trace
the income statement numbers
forward. Notice that gains and
losses are reported in the Other
Items section of the statement.
McGraw-Hill/Irwin
Slide 18
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 Net Income ÷ 28,1000,000 Shares =
$0.27
McGraw-Hill/Irwin
Slide 19
Key Ratio Analysis
Net Profit Margin indicates how effective
management is at generating profit on every
dollar of sales.
Net Profit
Margin
=
Net Income
Net Sales
Net profit margin for Papa John’s for January 2009 is:
$7,590,000
$70,730,000
McGraw-Hill/Irwin
= 10.7%
Slide 20
Statement of Stockholders’ Equity
Net income appears on the statement of stockholders’
equity as an increase in Retained Earnings.
From the income statement
Will appear on the balance sheet
McGraw-Hill/Irwin
Slide 21
Closing the Books
The following accounts are called temporary
or nominal accounts and are closed at the
end of the period . . .
• Revenues.
• Expenses.
• Gains.
• Losses.
• Dividends declared.
McGraw-Hill/Irwin
Slide 23
Closing the Books
Three steps are used in the
closing process . . .
1. Close revenues and gains to
Retained Earnings.
2. Close expenses and losses to
Retained Earnings.
3. Close dividends to Retained
Earnings.
McGraw-Hill/Irwin
Slide 24
Closing the Books
Here is an example of the closing process using an
illustration with just a few accounts.
McGraw-Hill/Irwin
Slide 25
Closing Entries for Papa John’s
Transfer net income to Retained Earnings.
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Slide 26
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 and dividend
accounts will have a zero balance.
McGraw-Hill/Irwin
Slide 27
Accruals and Deferrals: 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.
McGraw-Hill/Irwin
Slide 28
Miscellaneous Topics
Chart of Accounts
It is a listing of all accounts and
account numbers used by a business.
Assets are often numbered beginning with 1,
liabilities with 2, stockholders’ equity with 3,
revenues with 4, and expenses with 5.
McGraw-Hill/Irwin
Slide 30
Chart of Accounts
BALANCE SHEET ACCOUNTS:
Assets
101 Cash
111 Accounts Receivable
141 Office Supplies
151 Office Furniture
191 Land
Liabilities
Stockholders’ Equity
201 Accounts Payable 301 Common Stock
231 Notes Payable
311 Dividends
312 Retained Earnings
INCOME STATEMENT ACCOUNTS
(PART OF STOCKHOLDERS’ EQUITY):
•
Revenues
• 401 Service Revenue
•
•
McGraw-Hill/Irwin
Expenses
501 Rent Expense
502 Salary Expense
503 Utilities Expense
Slide 31
Normal Balances of the Accounts
Assets
Liabilities
Stockholders’ Equity – overall
Common stock
Retained earnings
Dividends
Revenues
Expenses
McGraw-Hill/Irwin
Debit
Credit
Credit
Credit
Credit
Debit
Credit
Debit
Slide 32
End of Chapter 4
© 2008 The McGraw-Hill Companies, Inc.