Adjustments,
Financial
Statements,
and the
Quality of Earnings
Chapter 4
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
4-2
Business Background
Management is
responsible for
preparing . . .
Financial
Statements
High Quality
= Relevance
+ Reliability
. . . Are useful
to investors
and creditors.
4-3
Business Background
Revenues are
recorded when
earned.
Expenses are
recorded when
incurred.
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.
4-4
Accounting Cycle
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.
4-5
Learning Objectives
Explain the purpose of a trial balance.
4-6
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.
4-7
Matrix, Inc.
Unadjusted Trial Balance
At December 31, 2006
Description
Debit
Cash
$
Accounts receivable
Inventory
Equipment
Accumulated depreciation - Equip.
Furniture and fixtures
Accumulated depreciation - furn. & fix.
Accounts payable
Notes payable
Note that
Common stock
total debits =
Retained earnings, 12/31/05
total credits
Sales revenue
Cost of goods sold
Operating expenses
Totals
$
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
4-8
Matrix, Inc.
Unadjusted Trial Balance
At December 31, 2006
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, 12/31/05
1,760
It is directly related to an 35,000
Sales revenue
Cost of goods sold
27,500
asset account but
has the
Operating expenses
6,300
opposite balance.
Totals
$
57,385
$
57,385
4-9
Matrix, Inc.
Unadjusted Trial Balance
At December 31, 2006
Description
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, 12/31/05
Sales revenue
Cost of goods sold
Operating expenses
Totals
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
4-10
The Unadjusted Trial Balance
If total debits do not equal total credits on the trial
balance, errors have occurred . . .
in preparing balanced
journal entries,
in posting the correct dollar
effects of a transaction,
or in copying ending balances
from the ledger to the
trial balance.
4-11
Learning Objectives
Analyze the adjustments necessary at the end
of the period to update balance sheet and
income statement accounts.
4-12
Adjusting Entries
There are two types of adjusting entries.
ACCRUALS
Revenues
earned or
expenses
incurred that
have not been
previously
recorded.
DEFERRALS
Receipts of
assets or
payments of
cash in advance
of revenue or
expense
recognition.
4-13
Proper Recognition of Revenues and Expenses
End of
accounting period.
Revenues earned
or
expense incurred.
Cash received
or paid.
Examples include interest earned during the period
(accrued revenue) or wages earned by employees but
not yet paid (accrued expense).
4-14
Recognizing Revenues in the Proper Period
When cash is
received prior to
earning revenue by
delivering goods or
services, the
company records a
journal entry to
recognize
unearned revenue.
4-15
Deferred Revenue
On December 1, 2006, Tom’s Rentals received a check for
$3,000, for the first four months’ rent from a new tenant.
The entry on December 1, 2006, to record the receipt of
the prepaid rent payment would be . . .
GENERAL JOURNAL
Date
Dec
Description
1 Cash
Unearned Rent Revenue
Debit
3,000
Credit
3,000
This is a LIABILITY account
4-16
Deferred Revenue
Received
cash for rent
<
12/1/06
4-month prepayment of rent
12/31/06
Year end
1/31/07
2/28/07
>
3/31/07
We must record the amount
of rent EARNED during December.
Since the prepayment is for 4
months, we can assume that 1/4 of
the rent will be earned each month.
4-17
Deferred Revenue
On December 31, 2006, Tom’s Rentals must adjust the
Unearned Rent Revenue account to reflect that one
month of rent revenue has been earned.
$3,000
× 1/4 = $750 per month.
GENERAL JOURNAL
Date
Description
Dec 31 Unearned Rent Revenue
Rent Revenue
Debit
750
Credit
750
In effect, our obligation to let them occupy the space for a
period of time has decreased because they used the
space for one month.
4-18
Accrued Revenue
End of
accounting period.
Revenues earned
Cash received
Example includes interest earned
during the period (accrued revenue).
4-19
Accrued Revenue
On October 1, 2006, Webb, Inc. invests $10,000 for 6 months
in a certificate of deposit that pays 6% interest per year.
Webb will not receive the interest until the CD matures on
March 31, 2007. On December 31, 2006, Webb, Inc. must
make an entry for the interest earned so far.
GENERAL JOURNAL
Date
Description
Dec 31 Interest
Receivable
What
Should Webb's
Interest
Revenue
Entry
Be?
$10,000 × 6% × 3/12 = $150
Debit
?150
Credit
?150
4-20
Chart for Deferred and Accrued Revenues
During the period Cash received before revenue earned
End of the period
Company has earned revenue
Next period
Cash is received
Deferred Revenue
Cash (+A)
Unearned revenue (+L)
Unearned revenue (-L)
Revenue (+R, + SE)
None
Accrued Revenue
None
Revenue receivable (+A)
Revenue (+R, +SE)
Cash (+A)
Revenue receivable (-A)
4-21
Recognizing Expenses in the Proper Period
When cash is paid prior to
incurring an expense, the
company records a journal
entry to recognize an asset.
An expense may be incurred
in the current period but not
paid until the next period.
The company must
recognize a liability.
4-22
Deferred Expense
End of
accounting period.
Cash paid.
Expense incurred.
Examples include prepaid rent, advertising,
and insurance.
4-23
Deferred Expense
On January 1, 2006, Matrix, Inc. paid $3,600 for a 3-year fire
insurance policy. They are paying in advance for a
resource they will use over a 3-year period.
The entry on January 1, 2006, to record the policy on
Matrix’s books would appear as follows . . .
GENERAL JOURNAL
Date
Jan.
Description
1 Prepaid Insurance Expense
Cash
Debit
3,600
This is an
ASSET account
Credit
3,600
4-24
Deferred Expense
Paid cash for
insurance
<
1/1/06
3-year insurance policy
12/31/06
Year end
12/31/07
Year end
>
12/31/07
Year end
At the end of 2006, we determine how much
of the “prepaid expense” has been used up
during the period.
Since the policy is for 3 years, we can
assume that 1/3 of the policy will expire
each year.
4-25
Deferred Expense
On December 31, 2006, Tipton must adjust the Prepaid
Insurance Expense account to reflect that 1 year of the
policy has expired.
$3,600
× 1/3 = $1,200 per year.
GENERAL JOURNAL
Date
Description
Dec 31 Insurance Expense
Prepaid Insurance Exp.
Page
Debit
1,200
365
Credit
1,200
In effect, the prepaid asset goes down▼,
while the expense goes up▲.
4-26
Accrued Expenses
Recall that accrued expenses
are expenses incurred in the
current period but not billed or
paid until the next accounting
period. Common examples
are interest expense incurred
on debt, wages expense owed
to employees, and utilities
expense.
4-27
Accrued Expenses
As of 12/27/06, Denton, Inc. had already paid $1,900,000 in
wages for the year. Denton pays its employees every
Friday. Year-end, 12/31/06, falls on a Wednesday. The
employees have earned total wages of $50,000 for
Monday through Wednesday of the week ending 1/02/07.
GENERAL JOURNAL
Date
Description
What
Should Denton's
Dec 31 Wages
Expense
Entry Be
on 12/31/04?
Wages
Payable
Debit
?
50,000
Credit
?
50,000
4-28
Chart for Deferred and Accrued Expenses
During the period
Cash paid before expense incurred
End of the period
Company must recognize expense
Next period
Cash is paid after expense incurred
Deferred Expense
Prepaid asset (+A)
Cash (-A)
Expense (+E)
Prepaid asset ((-A)
None
Accrued Expense
None
Expense (+E)
Liability (+L)
Liability (-L)
Cash (-A)
4-29
Adjustments Involving Estimates
Certain circumstances require
adjusting entries to record accounting
estimates.
 Examples include . . .

Depreciation
 Bad debts
 Income taxes

$$$
4-30
Adjustments Involving Estimates
Certain circumstances require
adjusting entries to record accounting
estimates.
Let’s look at the
 Examples include . . .

Depreciation
 Bad debts
 Income taxes

adjustment for
depreciation
expense.
4-31
Depreciation Adjustment
The accounting
concept of
depreciation involves
the systematic and
rational allocation of
the cost of a longlived asset over
multiple accounting
periods it is used to
generate revenue.
This is a “cost
allocation” concept,
not a “valuation”
concept.
4-32
Depreciation Adjustment
The journal entry required is to debit
Depreciation Expense and to credit an account
called Accumulated Depreciation.
GENERAL JOURNAL
Page
Date
Description
Dec 31 Depreciation Expense
Accumulated Depreciation
Debit
$$$$
352
Credit
$$$$
This is called a Contra-Asset
account.
4-33
Depreciation Adjustment
At January 1, 2004, Papa John’s trial balance
showed Accumulated Depreciation of
$149,000 (in thousands of dollars). For the
month of January, Papa John’s needs to
recognize $2,500 in depreciation.
GENERAL JOURNAL
Date
Description
Jan 31 Depreciation
What Should
Expense
Papa John's
Accumulated
Entry Be on 1/31/04?
Depreciation
Debit
2,500
?
Credit
2,500
?
4-34
Depreciation Adjustment
After we post the entry to the T-accounts, the
account balances look like this (in thousands
of dollars):
Depreciation
Expense
1/31
2,500
Bal.
2,500
Accumulated
Depreciation
1/1 149,000
1/31 2,500
Bal. 151,500
4-35
Financial Statement Preparation
The next step in the accounting cycle is
to prepare the financial statements. . .
Income statement,
 Statement of stockholders’ equity,
 Balance sheet, and
 Statement of cash flows.

4-36
Financial Statement Relationships
NetThe
income
income
increases
statement
retained
is created
earnings
first (a
net loss
by determining
decreases retained
the difference
earnings).
Dividends
betweendecrease
revenuesretained
and expenses.
earnings.
RETAINED
EARNINGS
Decrease
DIVIDENDS
Increase
NET
INCOME
=
REVENUES
–
EXPENSES
4-37
Financial Statement Relationships
Contributed Capital and
Retained Earnings make
up Stockholders’ Equity.
STOCKHOLDERS’
EQUITY
Increase
CONTRIBUTED
CAPITAL
RETAINED
EARNINGS
Increase
NET
INCOME
=
REVENUES
–
EXPENSES
4-38
Financial Statement Relationships
ASSETS
=
LIABILITIES
+
STOCKHOLDERS’
EQUITY
Increase
CONTRIBUTED
CAPITAL
RETAINED
EARNINGS
Increase
NET
INCOME
=
REVENUES
–
EXPENSES
4-39
Papa John's International, Inc. and Subsidiaries
Consolidated Statement of Income
Month Ended January 31, 2004
(in thousands of dollars)
Revenues:
Restaurant sales
$
Franchise fees
Total revenues
Costs and expenses:
Cost of sales
Salaries & benefits expense
General & administrative expenses
Depreciation expense
Total costs and expenses
Operating income
Other revenues and gains (expenses and losses)
Investment income
Interest expense
Gain on sale of land
Income before income taxes
Income tax expense
Net income
$
Earnings per share
$
66,000
3,800
69,800
36,000
16,000
8,100
2,500
62,600
7,200
1,000
(60)
3,000
11,140
3,899
7,241
0.40
The income
statement contains
revenues and
expenses.
Earnings Per
Share (EPS) must
be reported on
the income
statement.
4-40
Statement of Stockholders’ Equity
Net income appears on the statement of stockholders’
equity as an increase in Retained Earnings.
Papa John's International, Inc. and Subsidiaries
Consolidated Statement of Stockholders' Equity
For the Month Ended January 31, 2004
(in thousands of dollars)
Contributed
Capital
Beginning balance,
12/28/03
Stock Issuance
Net income
Dividends
Ending balance,
1/31/04
$
$
1,000 $
2,000
3,000 $
Retained
Earnings
158,000 $
Stockholders'
Equity
7,241
(3,000)
159,000
2,000
7,241
(3,000)
162,241 $
165,241
From the
Income
Statement
4-41
Statement of Cash Flows
This statement is a categorized list of all
transactions of the period that affected the
Cash account. The three categories are . . .
1. Operating activities,
2. Investing activities, and
3. Financing activities.
4-42
Statement of Cash Flows
Operating activities
Effect on Cash Flows
+/–
Investing activities
+/–
+/–
Total net cash flows for
Changes in cash
the period
+ Beginning cash balance
+
= Ending cash balance
Total
Financing activities
Supplemental Disclosure: (1) Interest paid, (2) income taxes
paid, and (3) a listing of the nature and amounts of significant
noncash transactions.
4-43
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 January 2004 is:
$7,241,000
$69,800,000
= 10.37%
4-44
Learning Objectives
Explain the closing process.
4-45
Closing the Books
Closing entries:
Even though the
1. Transfer net income (or
balance sheet
loss) to Retained
account balances
Earnings.
carry forward from
period to period, the 2. Establish a zero balance
in each of the temporary
income statement
accounts to start the next
accounts do not.
accounting period.
4-46
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.
4-47
Closing the Books
Assets, liabilities, and stockholders’ equity
are permanent, or real accounts, and are
never closed.
 Assets.
 Liabilities.
 Stockholders’ Equity.
4-48
Closing the Books
Two steps are used in the
closing process . . .
1. Close revenues and
gains to Retained
Earnings.
2. Close expenses and
losses to Retained
Earnings.
4-49
Post-Closing Trial Balance
Let’s take a look at the adjusted trial balance of
Matrix, Inc. at December 31, 2004. We want to
see the difference between the adjusted trial
balance and the post-closing trial balance.
4-50
Post-Closing Trial Balance
Matrix, Inc.
Adjusted Trial Balance
At December 31, 2004
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
4,000
Common stock
10,000
Retained earnings, 1/1/04
1,760
Sales revenue
35,000
Cost of goods sold
27,500
Operating expenses
6,300
Totals
$ 57,385 $ 57,385
Close these
accounts. Net
income is $1,200
4-51
Post-Closing Trial Balance
Matrix, Inc.
Post-Closing Trial Balance
At December 31, 2004
Description
Debit
Cash
$
Accounts receivable
Inventory
Equipment
Accumulated depreciation - Equip.
Furniture and fixtures
Accumulated depreciation - furn. & fix.
Accounts payable
Notes payable
Common stock
Retained earnings, 12/31/04
Sales revenue
Cost of goods sold
Operating expenses
Totals
Credit
3,900
4,985
3,300
4,800
$
1,440
6,600
2,200
2,985
4,000
10,000
2,960
-
$ 23,585 $ 23,585
Retained earnings
$2,960
($1,760 + $1,200
net income).
4-52
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.
4-53
End of Chapter 4