Financial Accounting, Second Canadian Edition

1
Chapter 4
Adjustments, Financial Statements, and the
Quality of Earnings
2
Business BackgroundThe Accounting Cycle
Start of the Accounting Period
Phase 1 During the Accounting Period (external
transactions)

• Perform transaction analysis.
• Record journal entries.
• Post amounts to general ledger.

• Prepare a trial balance.
• Analyze the account balances.
• Record and post adjusting entries.
• Prepare financial statements.
• Record and post closing entries.

Phase 2 End of the Accounting Period (internal
transactions)
End of the Accounting Period
3
Business Background
As indicated in Phase 1 of the Accounting Cycle,
external transactions between the business and
other external parties are recorded during the
period as they occur.
External Transactions
Adjusting Entries
End of Accounting Period
Start of Accounting Period

• At the end of the accounting period, the account
  balances are analyzed and adjusting journal
  entries are recorded for internal transactions
  that have a direct and measurable effect on the
  accounting entity, particularly for revenue and
  expense recognition.

4
The Unadjusted Trial Balance

• A listing of individual accounts, usually in
  financial statement order (A, L, SE, R, E).
• Ending debit or credit balances are listed in two
  separate columns.
• Total debit account balances should equal total
  credit account balances. Otherwise our basic
  accounting equation wont hold

5
Note that total debits total credits
6
Accumulated amortization is a contra-asset
account. It is directly related to an asset
account but has a credit balance. We use these to
show depreciation, ex of a car
7
Cost - Accumulated amortization NET BOOK
VALUE (ie. 4,800 - 1,440 3,360)
8
The Unadjusted Trial Balance

• If total debits do not equal total credits on the
  trial balance, errors have occurred . . .
• DOES YOUR TRIAL BALANCE BALANCE?

1) in preparing balanced journal entries. T
accounts
2) in posting the correct dollar effects of a
transaction. (to ledger)
3) in copying ending Balances from the ledger
to the trial balance.
3) Copying Balances to Wrong accounts
9
Adjusting Entries

• There are two types of adjusting entries.

10
Deferrals Example 1cash paid in advance. Ex
renew insurance policy
End of accounting period. (artifical breakpoint)
Example insurance paid in advance.
11
Deferrals - Example 1 cash paid in advance
Paid cash for insurance
lt 3-year insurance policy gt
1/1/05
12/31/05 Year end
12/31/06 Year end
12/31/07 Year end
Our goal is to record the amount of insurance
used up during 2005. Since the policy is for 3
years, we can assume that one third of the policy
will expire each year.
12
Deferrals - Example 1 cash paid in advance

• On January 1, 2005, Tipton, Inc. paid 3,600 for
  a 3-year fire insurance policy. The entry on
  January 1, 2005, to record the policy on Tiptons
  books would appear as follows . . .

13
Deferrals - Example 1 cash paid in advance

• On December 31, 2005, 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.

14
Deferrals - Example 1 cash paid in advance

• After we post the entry to the T-accounts, the
  account balances look like this

15
Deferrals Example 2 cash received in advance.
Ex you receive rent for your property, before
the person lives there.
End of accounting period.
Example rent received in advance.
16
Deferrals - Example 2 cash received in advance

• On December 1, 2005, Toms Rentals received a
  cheque for 3,000, for rent of an apartment for
  four months December to March.
• The entry on December 1, 2005, to record the
  receipt of the rent received in advance would be
  . . .

17
Deferrals - Example 2 cash received in advance
Received cash for rent
lt Cash received in advance for 4 months gt
Our goal is to 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.
18
Deferrals - Example 2 cash received in advance

• On December 31, 2005, Toms Rentals must adjust
  the Unearned Rent Revenue account to reflect that
  1 month of rent revenue has been earned.
• 3,000 1/4 750 per month.

19
Deferrals - Example 2 cash received in advance

• After we post the entry to the T-accounts, the
  account balances look like this

20
Accruals

• Accruals occur when revenues have been earned
  or expenses incurred but no cash has been
  exchanged.
• This is the opposite of the last two examples

21
Accruals - Example 1 cash received after end of
fiscal period
End of accounting period.
Example interest earned during the period but
not received until the next period.
22
Accruals - Example 1 cash received after end of
fiscal period

• On October 1, 2005, Webb, Inc. invests 10,000
  for 6 months in a certificate of deposit (CD)
  that pays 6 interest per year. Webb will not
  receive the interest until the CD matures on
  March 31, 2006. On December 31, 2005, Webb, Inc.
  must make an entry for the interest earned so far.

23
Accruals - Example 1cash received after end of
fiscal period

• After we post the entry to the T-accounts, the
  account balances look like this

24
Accruals Example 2 cash paid after end of
fiscal period
End of accounting period.
Example wages earned by employees during this
period but not paid until the next period.
25
Accruals - Example 2 cash paid after end of
fiscal period

• As of Dec. 24, 2005, Denton, Inc. had already
  paid 1,900,000 in wages for the year. Denton
  pays its employees every other Friday. The
  year-end, Dec. 31, 2004, falls on a Friday. The
  employees have earned total wages of 50,000 for
  Monday, Dec. 27 through Friday, Dec. 31, 2005.

26
Accruals - Example 2 cash paid after end of
fiscal period

• After we post the entry to the T-accounts, the
  account balances look like this

Wages Expense (E)
As of 12/24
12/31 1900000 50,000
Bal.
27
Accounting Estimates

• Certain circumstances require adjusting entries
  to record accounting estimates.
• Examples include . . .
• Amortization
• Bad debts
• Income taxes

Lets look at how we handle amortization expense.
28
Amortization
This is a cost allocation concept, not a
valuation concept.
The accounting concept of amortization involves
the systematic and rational allocation of the
cost of a long-term asset to the periods during
which it is used to generate revenue.
29
Amortization
The required journal entry includes a debit to
Amortization expense and a credit to an account
called Accumulated amortization.
As discussed earlier, this is called a
Contra-Asset account. It is listed in asset side,
but has a credit as opposed to the traditional
debit balance of asset accounts Sometimes called
Depreciation
30
Estimates - Example 1amortization

• At April 30, 2005, Van Houttes trial balance
  showed Property and equipment of 256,600 (all
  numbers in thousands) and Accumulated
  amortization of 139,100. For the period, Van
  Houtte needs to record an additional 1,900 in
  amortization.

31
Estimates - Example 1 amortization

• After we post the entry to the T-accounts, the
  account balances look like this

Accumulated Amortization (XA)
12/31 139,100
1/31 1,900
Bal. 141,000 (how much weve used up)
32
Financial Statement Preparation

• From the adjusted Trial Balance we create our
  statements.
• The next step in the accounting cycle is to
  prepare the financial statements. . .
• 1) Income statement (easiest to create first.
  Income caries forward into 2),
• 2) Statement of retained earnings,
• 3) Balance sheet, and
• 4) Cash flow statement.

33
Financial Statement Relationships
The income statement is created first by
determining the difference between revenues and
expenses.
Net income increases retained earnings, while a
net loss will decrease retained earnings.
Dividends decrease retained earnings.
RETAINED EARNINGS
DIVIDENDS
NET INCOME


REVENUES
EXPENSES
34
Financial Statement Relationships
Share Capital and R/E make up Shareholders
Equity.
SHAREHOLDERS EQUITY
SHARE CAPITAL
RETAINED EARNINGS
DIVIDENDS
NET INCOME


REVENUES
EXPENSES
35
Financial Statement Relationships
SHARE CAPITAL
RETAINED EARNINGS
DIVIDENDS
NET INCOME


REVENUES
EXPENSES
36
Financial Statement Relationships
37
Note that this statement has ONLY revenues and
expenses!
Earnings Per Share (EPS) must be reported on the
income statement.
38
Income Statement

• EPS for Van Houtte is based on 21,598,000 shares
  outstanding and net income of 6,360,000.
• If the outstanding shares is different at the
  start and end of year we calculate a weighted
  average

39
Cash Flow Statement General Model
40
Net Profit Margin
Net Profit Margin gives an indication of how
effective management is at generating profit on
every dollar of sales. How much are we retaining
for each dollar of sales we do. Walmart has low
profit margins and high volume. If you have low
volume, you better have high profit margins. Cars
have a high profit margin. Walmart is low. The
most interesting part of this ratio is comparing
year to year of the same company.
From the 2005 income statement, Van Houtte had
net income of 21,706 on sales of 348,755 giving
them a net profit margin of 6.22
41
The Closing Process

• Even though the balance sheet account balances
  carry forward from period to period, the income
  statement accounts do not.

• Closing entries
• Transfer net income (or loss) to Retained
  Earnings.
• Establish a zero balance in each of the temporary
  accounts to start the next accounting period.

42
The Closing Process
Assets, liabilities, and shareholders equity
accounts are permanent, or real accounts, and are
never closed . . .the ending balance from one
year becomes the beginning balance of the
next Dividends are an exception, and get closed
out every year
The following accounts are called temporary or
nominal accounts and are closed at the end of the
period . . . Includes dividends Revenues and
Expenses normal activity. Gains and Losses
exceptional activity

• Assets
• Liabilities
• Shareholders Equity

• Revenues
• Expenses
• Gains
• Losses, and
• Dividends declared

43
The Closing Process

• Three steps are used in the closing process . . .
• 1) Close revenues and gains (credit) to Retained
  Earnings.
• 2) Close expenses and losses (debit) to Retained
  Earnings.
• 3) Close dividends to Retained Earnings.

44
The Closing Process
To close Van Houtte Revenue accounts, the
following entry is required (just debit the
revenue accounts for the amount of their ending
credit, unless the contra-revenue account is in
the debit position)
45
The Closing Process

• If we close the other revenue accounts in a
  similar fashion, the retained earnings account
  looks like this . . .
• Closing your revenues they become a credit in
  your retained earnings

46
The Closing Process
To close Van Houtte expense accounts, the
following entry is required Close all your
expense accounts with credits of the amount of
their current Debit status.
47
The Closing Process

• If we close the other expense accounts in a
  similar fashion, the retained earnings account
  looks like this . . .
• The debits become debits of retained earnings.
  Each expense accounts (losses) will decrease
  retained earnings

48
The Closing Process

• Finally, we close dividends to Retained
  Earnings and the account looks like this . . .
• We will close dividends account by crediting
  dividendsPaid and debit retained earnings
  (decrease retained earnings)

49
Post-closing Trial Balance

• Post-closing Trial Balance should be prepared as
  the last step of the accounting cycle to check
  that debits equal credits and all temporary
  accounts have been closed.This is the third
  trial balance, after unadjusted, and adjusted.
• The only accounts should be assets, liabilities,
  and SE. All others should be closed out (0)
  (zero) (nada)