Adjustments, Financial Statements, and the Quality of … · Adjustments, Financial Statements, and the Quality of Earnings ... for standard distribution ... Accounts receivable 4,985

Adjustments, Financial Statements, and the Quality of Earnings

Chapter 4

McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, Inc.

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McGraw-Hill/Irwin Slide 2

Understanding the Business

Management is

responsible for

preparing . . .

Financial Statements

Financial statements have formal guidance

in preparation and presentation

Publicly-traded firms

Privately –held firms

Non-profit firms

Financial statements have targeted audiences

for standard distribution

Publicly-traded firms

Privately –held firms

Non-profit firms


Understanding the Business

Management is

responsible for

preparing . . .

. . . Are useful

to investors

and creditors.

Financial Statements

High Quality

= Relevance

+ Reliability

Accounting Cycle

Prepare financial statements.

Disseminate statements to users.

Close revenues,

gains, expenses, and

losses to Retained

Earnings.

During the period:

Analyze transactions.

Record journal entries.

Post amounts to general

ledger.

At the end of the period: Adjust revenues and

expenses.

Start of Period


Purpose of Adjustments

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.

Matching Principle

3-6

• A natural link (cause and effect) exists between

revenues and some types of expenses

– Sales commissions (percentage of collected sales)

– Cost of goods sold (if sales = $0, costs = $0)

• Some expenses are not linked with sales but with a

particular time period

– Rent expense

– Salary expense (monthly or hourly

Matching Principle


Adjustment Process

• Adjusting entries can be grouped into

three basic categories: – Deferrals (revenue or expense into future period)

• An adjustment of an asset or a liability for which the business paid

or received cash in advance

– Accruals (revenue or expense into current period) • The recording of an expense or a revenue before paying or

receiving cash

– Depreciation • The systematic allocation of the cost of a plant asset to expense

over the asset’s useful life


Types of Adjustments

There are four types of adjustments.

Expenses

3. Prepaid

Expenses.

4. Accrued

Expenses.

Revenues

1. Unearned

Revenues.

2. Accrued

Revenues.

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.


Trial Balance

• The trial balance – Is a list of all accounts with their balances

• Assets first, followed by liabilities and then stockholders’ equity

– Aids in the preparation of the financial statements

by summarizing all the account balances

– Provides a check on accuracy by showing whether

total debits equal total credits


Matrix, Inc.


At December 31, 2009

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, 12/31/08 1,760

Sales revenue 35,000

Cost of goods sold 27,500

Operating expenses 6,300

Totals 57,385$ 57,385$

Note that

total debits =

total credits


Matrix, Inc.




Cash 3,900$


Inventory 3,300

Equipment 4,800





Notes payable 4,000

Common stock 10,000





Totals 57,385$ 57,385$

Accumulated depreciation

is a contra-asset account.

It is directly related to an

asset account but has the

opposite balance.


Matrix, Inc.




Cash 3,900$


Inventory 3,300

Equipment 4,800





Notes payable 4,000

Common stock 10,000





Totals 57,385$ 57,385$

Cost - Accumulated depreciation =

BOOK VALUE.


End of accounting period.

Cash received. Revenues earned.

Example includes rent received in

advance (an unearned revenue).

Unearned Revenues


Unearned Revenues

On December 1, 2009, Tom’s Rentals received a check for $3,000, for the first four months’ rent from a new tenant.

The adjustment on December 31, 2009, to reduce the liability and record the revenue earned would be:

$3,000 × 1/4 = $750 per

month.


Unearned Revenues

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

Unearned Rent

Revenue

12/31 750 12/1 3000

Bal. 2,250

Rent Revenue

12/31 750

Bal. 750



Cash received Revenues earned

Example includes interest earned

during the period (accrued revenue).

Accrued Revenue


Accrued Revenue

At December 31st, Matrix, Inc. earned, but has not received, interest on its money market account of $150. The adjustment is made to debit Interest

Receivable and credit Interest Revenue.

Interest Receivable

12/31 150

Bal. 150

Interest Revenue

12/31 150

Bal. 150



Cash paid.

Examples include prepaid rent,

advertising, and insurance.

Prepaid Expenses

Expense incurred.


Prepaid Expenses

On January 1, 2009, 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.

At December 31st, Matrix must recognize the portion of the insurance that has been consumed and becomes an expense.

$3,600 × 1/3 = $1,200 per

year.


Prepaid Expenses


Prepaid

Insurance Expense

1/1 3,600 12/31 1,200

Bal. 2,400

Insurance Expense

12/31 1,200

Bal. 1,200

Remaining two years of insurance

at $1,200 per year.



Expense incurred.

Examples include accrued rent,

accrued interest, and accrued wages.

Accrued Expenses

Expense paid.


GENERAL JOURNAL

Date Description Debit Credit

Dec 31 ?

?

What Should Denton's

Entry Be on 12/31/04?

GENERAL JOURNAL


Dec 31 Wages Expense 50,000

Wages Payable 50,000

Accrued Expenses

As of 12/27/09, Denton, Inc. had already paid $1,900,000 in wages for the year. Denton pays its employees every Friday. Year-end, 12/31/09, falls on a Wednesday. The employees have earned total wages of $50,000 for Monday through

Wednesday of the week ending 1/02/10.


Accrued Expenses


Wages Payable

12/31 50,000

Bal. 50,000

Wages Expense

$1,900,000

Bal. $1,950,000

As of

12/27

12/31 50,000

Certain circumstances require adjusting entries to record accounting estimates.

Examples include . . . Depreciation

Bad debts

Income taxes

Accrued Expenses Involving Estimates

Depreciation Bad debts Income taxes

13. Property and Equipment

Property and equipment are recorded at cost, less accumulated depreciation. Depreciation is computed

using the straight-line method over estimated useful lives or lease term if shorter. We amortize leasehold

improvements purchased after the beginning of the initial lease term over the shorter of the assets’ useful lives

or a term that includes the original lease term, plus any renewals that are reasonably assured at the date the

leasehold improvements are acquired. Depreciation expense for 2008, 2007 and 2006 was $1,804 million,

$1,644 million and $1,509 million, respectively. For income tax purposes, accelerated depreciation methods

are generally used. Repair and maintenance costs are expensed as incurred and were $609 million in 2008,

$592 million in 2007 and $532 million in 2006. Facility pre-opening costs, including supplies and payroll, are

expensed as incurred.

Estimated Useful Lives Life (in years)

Buildings and improvements 8-39

Fixtures and equipment 3-15

Computer hardware and software 4-7

Long-lived assets are reviewed for impairment annually and also when events or changes in

circumstances indicate that the asset’s carrying value may not be recoverable. No material impairments were

recorded in 2008, 2007 or 2006 as a result of the tests performed.

22. Income Taxes

We account for income taxes under the asset and liability method. We have recognized deferred tax

assets and liabilities for the estimated future tax consequences attributable to differences between the

financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred

tax assets and liabilities are measured using enacted income tax rates in effect for the year the temporary

differences are expected to be recovered or settled.

We estimate future write-offs based on historical experience of

delinquencies, risk scores, aging trends, and industry risk trends. Substantially all accounts continue to

accrue finance charges until they are written off. Total accounts receivable past due ninety days or more and

still accruing finance charges were $393 million at January 31, 2009 and $235 million at February 2, 2008.

Accounts are written off when they become 180 days past due.

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Preparing Financial Statements

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.


The income statement is created first

by determining the difference

between revenues and expenses.

Net income increases retained earnings (a

net loss decreases retained earnings).

Dividends decrease retained earnings.

Financial Statement Relationships

RETAINED

EARNINGS

REVENUES EXPENSES – NET

INCOME =

DIVIDENDS Decrease

Increase


STOCKHOLDERS’

EQUITY


CONTRIBUTED

CAPITAL

RETAINED

EARNINGS

Contributed Capital and

Retained Earnings make

up Stockholders’ Equity.

Increase


INCOME =

Increase


ASSETS LIABILITIES STOCKHOLDERS’

EQUITY = + STOCKHOLDERS’

EQUITY


CONTRIBUTED

CAPITAL

RETAINED

EARNINGS

Increase


INCOME =

Increase

Papa John's International, Inc. and Subsidiaries

Consolidated Statement of Income

Month Ended January 31, 2007

(in thousands of dollars)

Revenues:

Restaurant sales revenue 66,000$

Franchise fees revenue 4,730

Total revenues 70,730

Costs and expenses:

Cost of sales 30,000

Salaries expense 16,000

General & administrative expenses 14,100

Depreciation expense 2,500

Total costs and expenses 62,600

Operating income 8,130

Other revenues and gains (expenses and losses)

Investment income 1,070

Interest expense (550)

Gain on sale of land 3,000

Income before income taxes 11,650

Income tax expense 3,961

Net income 7,689$

Earnings per share 0.23$

The income

statement

contains

revenues and

expenses.

Earnings Per

Share (EPS) must

be reported on

the income

statement.


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, 2007


Contributed

Capital

Retained

Earnings

Stockholders'

Equity

Beginning balance 1,000$ 147,000$ 148,000$

Stock Issuance 2,000 2,000

Net income 7,689 7,689

Dividends (3,000) (3,000) Ending balance 3,000$ 151,689$ 154,689$

From the

Income

Statement


Balance Sheet - Assets

Papa John's International, Inc. & Subsidiaries

Consolidated Balance Sheet

January 31, 2007


Assets

Current Assets:

Cash 43,900$


Supplies Interest receivable 70

Supplies 22,000

Prepaid expenses 14,500

Other current assets 14,000

Total current assets 114,500

Long-term investments 2,000

Property and equipment (net of

accumulated depreciation of $191,500) 204,500

Long-term notes receivable 15,000

Intangibles 67,000

Other assets 17,000

Total assets 420,000$

General & administrative expenses 6,910

Depreciation & amortization 1,670

Other costs & expenses 10

Total cost & expenses 428,590

Income before income taxes (414,090)

Income tax expense 5450

Net income (419,540)$

Earnings per share (14.266)$

$396,000 cost –

$191,500

accumulated

depreciation is

equal to $204,500.


Balance Sheet – Liabilities & Stockholders’ Equity

Papa John's International, Inc. & Subsidiaries

Consolidated Balance Sheet

January 31, 2007


Liabilities and stockholders' equity

Current liabilities

Accounts payable 39,000$

Dividends payable 3,000

Accrued expenses payable 76,150

Income taxes payable 3,961

Total current liabilities 122,111

Unearned franchise fees 6,200

Notes payable 110,000

Other long-term liabilities 27,000

Total liabilities 265,311

Stockholders' equity

Contributed capital 3,000

Retained earnings 151,689

Total stockholders' equity 154,689

Total liabilities and stockholders'

equity $ 420,000

From the

Statement of

Stockholders’

Equity.


Focus on 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.


Focus on Cash Flows

Disclosures 1.Cash interest paid. 2.Cash income taxes paid. 3.A schedule of significant noncash investing and financing transactions.


Net Profit Margin

Net Profit Margin indicates how effective

management is at generating profit on every

dollar of sales.

Net Income

Net Sales Net Profit

Margin =

Net profit margin for Papa John’s for 2006 is:

$63,375,000

$1,001,557,800 = 6.33%


Closing the Books

Even though the balance sheet account balances

carry forward from period to period, the

income statement accounts do not.

Closing entries:

1. Transfer net income (or loss) to Retained Earnings.

2. Establish a zero balance in each of the temporary accounts to start the next accounting period.


Example of the “Closing Concept”

When you go to sleep at night ….

When you wake-up in the morning


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.


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 (if listed)


GENERAL JOURNAL Page 365


Jan 31 Restaurant Sales Revenue 66,000

Retained Earnings 66,000

To close Papa John’s Restaurant Sales Revenue

account, the following entry is required:

144,000 1/31/07

66,000 Close

Retained Earnings

66,000 66,000

Sales Revenue

Restaurant

Closing the Books


GENERAL JOURNAL Page 365


Jan 31 Retained Earnings 30,000

Cost of Sales - Restaurants 30,000

To close Papa John’s Cost of Sales - Restaurants

account, the following entry is required:

30,000 30,000 Close

Restaurants

Cost of Sales

30,000 144,000

66,000

Retained Earnings

Closing the Books


Closing Entries

Dec 31 Service Revenue 5,000

Retained Earnings 5,000

Dec 31 Retained Earnings 4,400

Cost of Goods Sold 1,000

Salary Expense 2,000

Supplies Expense 300

Depreciation Expense 200

Utilities Expense 400

Income Tax Expense 500


Closing the Books

Assume we have closed all other revenue and

expense accounts, and that dividends declared

are recognized in a separate dividend

account, which is closed to Retained Earnings at the end of the period.

Close 30,000 144,000 1/1/07

Close 16,000 66,000 Close




Close 500

Close 600

Close 2,500

Close 550

Close 3,961

67,111 218,800

151,689 Ending Bal.

Retained Earnings


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 accounts will have a

zero balance.


•Record ongoing transactions

•Post to ledger

•Prepare Trial Balance

•Record adjusting entries

•Prepare Adjusted Trial Balance

•Prepare financial statements Income Statement

Statement of Stockholders’ Equity

Balance Sheet

Statement of Cash Flows

•Record closing entries Revenues set to zero

Expenses set to zero

•Post-closing Trial Balance

Ed’s Accounting Advice


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.

© 2008 The McGraw-Hill Companies, Inc.

End of Chapter 4

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Adjustments, Financial Statements, and the Quality of … · Adjustments, Financial Statements, and the Quality of Earnings ... for standard distribution ... Accounts receivable 4,985