Chapter 4 - Adjustments, Financial Statements and the Quality of Earnings
1) Explain the acocunting information processing cycle.
The accounting information processing cycle is a series of sequential phases (or steps) used in an
accounting system to process data from the initial transactions to the end products – the periodic
financial statements – and prepare the records for the next accounting cycle.
2) Identify, in sequence, the phases of the accounting information processing cycle.
Phase 1 During the period: Perform transaction analysis, record journal entries, and post amounts
to the general ledger (T-accounts).
Phase 2 End of the period: Prepare a trial balance, analyze account balances and prepare
adjustments, record and post adjusting journal entries, prepare financial statements, and prepare and
post the closing entries.
3) Briefly explain adjusting entries. List the four types of adjucting entries, and give an example of
each type.
Adjusting entries are made at the end of the accounting period to record appropriate amounts of
revenue, expenses, assets, liabilities and shareholders’ equity.
The four different types are adjustments for:
(a) Deferred expenses – previously recorded assets that need to be adjusted at the end of the period
to reflect expenses that have been incurred or used up during the period (e.g., prepaid insurance
must be adjusted for the portion of insurance expense incurred in the current period).
(b) Deferred revenues – previously recorded liabilities that need to be adjusted at the end of the
period to reflect revenues that have been earned during the period (e.g., deferred revenue must be
adjusted for the portion of revenues earned in the current period).
(c) Accrued revenues – revenues that have been earned by the end of the accounting period but
which will be collected in a future accounting period (e.g., recording interest receivable for interest
earned but not yet collected).
(d) Accrued expenses – expenses that have been incurred by the end of the accounting period but
which will be paid in a future accounting period (e.g., recording an expense and a corresponding
accrued liability for utilities used during the period but not yet paid).
4) What is a trial balance? What is its purpose?
A trial balance is a list of individual accounts, usually in financial statement order (assets, liabilities,
shareholders’ equity, revenues, and expenses), with their debit or credit balances. It is used to
provide a check on the equality of the debits and credits.
5) What is a contra asset? Give an example of one.
A contra-asset is an account that is directly related to another account but has an opposite balance.
The contra account is shown as a reduction to the regular account’s balance. Accumulated
Depreciation is a contra-account to the equipment and buildings accounts.
6) Explain why adjusting entries are entered in the journal on the last day of the accounting period
and then are posted to the ledger.
Adjusting entries are recorded in the journal on the last day of the accounting period because (a)
they record economic effects not adequately measured by the regular entries up to that date and (b)
they represent economic events in the same sense as the other transactions. They are necessary to
measure net earnings for that period properly, correct errors, and provide for adequate valuation of
statement of financial position accounts. Adjusting entries are posted to the ledger to adjust the
balances of certain accounts on the statement of earnings and the statement of financial
position.Adjusting entries are recorded in the journal on the last day of the accounting period
because (a) they record economic effects not adequately measured by the regular entries up to that
date and (b) they represent economic events in the same sense as the other transactions. They are
necessary to measure net earnings for that period properly, correct errors, and provide for adequate
valuation of statement of financial position accounts. Adjusting entries are posted to the ledger to
adjust the balances of certain accounts on the statement of earnings and the statement of financial
position.
7) Explain how the financial statements relate to each other.
The net earnings on the statement of earnings is added to the opening balance in the statement of
retained earnings. The deduction of dividends declared during the period leads to the ending
balance of retained earnings which is reported on the statement of financial position. The change in
the cash account on the statement of financial position is analyzed and categorized on the statement
of cash flows into cash from (or used in) operating activities, investing activities, or financing
activities.
8) What is the equation for each of the following : (a) statement of earnings, (b) the retained
earnings component of the statement of changes in equity, (c) statement of financial position and
(d) statement of cash flows?
(a) Statement of Earnings: Net earnings = (Revenues + Gains) – (Expenses + Losses)
(b) Statement of Retained Earnings: Ending Retained Earnings = Beginning
Retained Earnings
+ Net Earnings – Dividends Declared
(c) Statement of financial position: Assets = Liabilities + Shareholders’ Equity
(d) Statement of cash flows: Changes in cash for the period = Cash from (used in)
Operations + Cash from (used in) Investing Activities + Cash from (used in) Financing Activities
9) Explain the effect of adjusting entries on cash.
Adjusting entries have no effect on cash. For deferrals, cash was already received or paid during
the current or previous accounting periods. For accruals, cash will be received or paid in a future
accounting period. At the effective date of the adjusting entry, e.g., December 31, no cash is being
received or paid.
10) How is earnings per share computed and interpreted?
In its simplest form Earnings per Share (EPS) is computed by dividing net earnings by the weighted
average number of common shares outstanding during the period. EPS measures the average
amount of net earnings for the year attributable to one common share. It is important to note that
this does not necessarily mean that the shareholder will actually receive this amount as dividends.
11) Contrast an unadjusted trial balance with an adjusted trial balance. What is the purpose of
each?
An unadjusted trial balance is prepared after all current transactions have been journalized and
posted to the ledger. It does not include the effects of the adjusting entries. The basic purpose of an
unadjusted trial balance is to check the equalities of the accounting model (particularly, Debits =
Credits) and to provide the data in a form convenient for further processing in the accounting
information processing cycle.
In contrast, an adjusted trial balance is prepared after the effects of all of the adjusting entries have
been applied to the corresponding (prior) unadjusted trial balance amounts. The basic purpose of an
adjusted trial balance is to ensure that accuracy has been attained in applying the effect of the
adjusting entries. The adjusted trial balance provides a second check of equalities in the accounting
model (primarily Debits = Credits). It also provides information in a convenient form for
preparation of the financial statements.
12) Why does net earnings differ from cash flow from operations? Explain.
Net earnings is the result of subtracting all accrued expenses from all accrued revenue. Accrual
means that an enforceable obligation exists for customers to pay for a service or product that has
been provided. Therefore, the seller can recognize the dollar value of the sale even though cash has
not been received. Similarly an enforceable obligation exists for the seller to pay for resources
purchased even though the cash has not yet been paid out. Accruals are subject to specific time
periods wherein they must be recognized. Cash flow from operations reports only the cash received
and paid by a company during a specified time period in relation to its regular operations.
13) What is the practical importance of the concept of materiality to preparers, auditors, and users
of financial statements?
Materiality refers to the relative significance of financial information with respect to its influence on
economic decisions made by financial statement users. If a misstatement or omission of
information would cause a change in a decision, then the item is material. This concept allows
accountants and auditors to ignore trivial differences among estimated values that would not
influence a decision. Materiality is clearly related to relevance. An immaterial item is also an
irrelevant item in the context of decision making.
14) What is the meant by the "quality of earnings"?
The quality of earnings refers to the relationship between net earnings and cash flow from operating
activities. The measurement of revenues and expenses under the accrual basis of accounting
requires the use of estimates. Those firms that make relatively pessimistic estimates that reduce
current net earnings are judged to follow conservative financial reporting strategies, and their
reports of performance are given more credence. The earnings numbers reported by these
companies are often said to be of “higher quality” because they are less influenced by
management’s natural optimism. Firms that consistently make optimistic estimates that result in
reporting higher net earnings, however, are judged to be aggressive. Analysts judge these
companies’ operating performance to be of lower quality.
15) What is the purpose of closing entries? Why are they recorded in the journal and posted to the
ledger
Closing entries are made at the end of the accounting period to transfer the balances in the
temporary statement of earnings accounts to retained earnings. The closing entries reduce the
revenue, gain, expense, and loss accounts to a zero balance so that they can be used for the
accumulation process during the next period. Closing entries must be entered into the system
through the journal and then posted to the ledger accounts so that appropriate balances are shown in
the temporary and permanent accounts (i.e., zero balances in the temporary accounts).
16) Differentiate among permanent, temporary, real and nominal accounts.
(a) Permanent accounts – statement of financial position accounts; that is, the asset, liability, and
shareholders’ equity accounts (these are not closed at the end of each period). Shareholders’ equity
accounts include Share Capital and Retained Earnings.
(b) Temporary accounts – statement of earnings accounts; that is, all the revenue, gain; expense,
and loss accounts that are closed at the end of each period.
(c) Real accounts – another name for permanent accounts.
(d) Nominal accounts – another name for temporary accounts.
17) Why are the statement of earnings accounts closed, but the statement of financial position
accounts are not?
The statement of earnings accounts are closed at the end of the accounting period because they are,
in effect, temporary sub-accounts to retained earnings (i.e., a part of shareholders’ equity). They are
used only for accumulation during the accounting period. When the period (usually one year) ends,
these accumulated amounts must be transferred (closed) to retained earnings. The closing process
serves two main purposes, namely (1) to correctly state the balance of retained earnings at the end
of the period, and (2) to clear out the balances of the temporary accounts for the period just ended
so that these accounts can be used again during the next period for accumulation and classification
purposes.
Statement of financial position accounts are not closed at the end of the period because they reflect
permanent accumulated balances of asset, liability, and equity accounts. Permanent accounts show
the entity's financial position at the end of the period and reflect the beginning amounts for the next
period.
18) What is a post-closing trial balance? Is it a useful part of the accounting information
processing cycle? Explain.
A post-closing trial balance is a listing taken from the ledger after the adjusting and closing entries
have been journalized and posted. It is not a necessary part of the accounting information
processing cycle but it is useful because it demonstrates the equality of the debits and credits in the
ledger after the closing entries have been journalized and posted. It also provides a check on the
ending balance in retained earnings.
19) How is the net profit margin ratio computed and interpreted?
Net profit margin = Net earnings ÷ Net sales
The net profit margin measures how much of every sales dollar generated during the period is
profit. Net profit margin is the most basic measure of profitability since the ratio shows how much
of each sales dollar flows to the “bottom line”.
20) How is the return on equity computed and interpreted?
Return on Equity = Net Earnings / Average Shareholders’ Equity
Average Shareholders’ Equity = (Beginning SE + Ending SE) / 2
ROE measures how much the firm earned as a percentage of shareholders’ investment.