chap004 - Adjustments, Financial Statements, and the...

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Unformatted text preview: Adjustments, Financial Statements, and the Quality of Earnings the Chapter 4 Understanding the Business Management is Management responsible for preparing . . . preparing Financial Statements High Quality High = Relevance + Reliability Reliability . . . Are useful Are to investors and creditors. and 4-2 Accounting Cycle Start of Period During the period: q Analyze transactions. q Record journal entries. q Post amounts to general ledger. q q At the end of the period: q Adjust revenues and expenses. q Close revenues, gains, expenses, and losses to Retained Earnings. Prepare financial statements. Disseminate statements to users. 4-3 Purpose of Adjustments Revenues are recorded when earned. Expenses are recorded when incurred. Matching Principle Because transactions occur over time, ADJUSTMENTS are Because required at the end of each fiscal period to get the revenues and expenses into the “right” period. and 4-4 Types of Adjustments There are four types of adjustments. Revenues 1. Unearned Revenues. Expenses 1. Prepaid Expenses. 2. Accrued Revenues. 2. Accrued Expenses. 4-5 Note that total debits = total credits 4-6 Unearned Revenues End of accounting period. Cash received. Revenues earned. Example includes rent received in Example advance (an unearned revenue). advance 4-7 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. 4-8 Unearned Revenues After we post the entry to the T-accounts, the After account balances look like this: account Unearned Rent Revenue 12/31 750 12/1 3000 Bal. 2,250 Rent Revenue 12/31 750 Bal. 750 4-9 Accrued Revenue End of accounting period. Revenues earned Cash received Example includes interest earned during the period (accrued revenue). 4-10 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 4-11 Prepaid Expenses End of accounting period. Cash paid. Expense incurred. Examples include prepaid rent, Examples advertising, and insurance. advertising, 4-12 Prepaid Expenses On January 1, 2009, Matrix, Inc. paid $3,600 for a 3-year fire On insurance policy. They are paying in advance for a resource they will use over a 3-year period. resource At December 31st, Matrix must recognize the portion of the At Matrix insurance that has been consumed and becomes an expense. expense. $3,600 $3,600 × 1/3 = $1,200 per year. 4-13 Prepaid Expenses After we post the entry to the T-accounts, the account balances look like this: 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. 4-14 Accrued Expenses End of accounting period. Expense incurred. Expense paid. Examples include accrued rent, Examples accrued interest, and accrued wages. accrued 4-15 Accrued Expenses As of 12/27/09, Denton, Inc. had already paid As $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. 4-16 Accrued Expenses After we post the entry to the T-accounts, the account balances look like this: Wages Expense As of 12/27 $1,900,000 12/31 50,000 Bal. Wages Payable 12/31 50,000 Bal. 50,000 $1,950,000 4-17 Accrued Expenses Involving Estimates Certain circumstances require adjusting entries to record accounting estimates. Examples include . . . Depreciation Bad debts Income taxes 4-18 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. 4-19 Financial Statement Relationships Net he income statement is created first (a T income increases retained earnings The net lossdeterminingretained earnings). by decreases the difference Dividends drevenues and expenses. between ecrease retained earnings. between RETAINED EARNINGS Decrease DIVIDENDS Increase NET INCOME = REVENUES – EXPENSES 4-20 The income statement contains revenues and expenses. Earnings Per Earnings Share (EPS) must be reported on the income statement. statement. 4-21 Statement of Stockholders’ Equity Net income appears on the statement of stockholders’ equity as an increase in Retained Earnings. From the Income Statement 4-22 Balance Sheet - Assets $396,000 cost – $396,000 $191,500 accumulated depreciation is equal to $204,500. equal 4-23 Balance Sheet – Liabilities & Stockholders’ Equity From the From Statement of Stockholders’ Equity. Equity. 4-24 Focus on Cash Flows This statement is a categorized list of all This transactions of the period that affected the Cash account. The three categories are . . . 1. 1. 2. 3. Operating activities, Operating Investing activities, and Investing Financing activities. Financing 4-25 Focus on Cash Flows Disclosures 1.Cash interest paid. 2.Cash income taxes paid. 3.A schedule of significant noncash investing schedule and financing transactions. 4-26 Net Profit Margin Net Profit Margin indicates how effective Net management is at generating profit on every dollar of sales. dollar Net Profit Margin = Net Income Net Sales Net profit margin for Papa John’s for 2006 is: $63,375,000 $1,001,557,800 = 6.33% 6.33% 4-27 Closing the Books Closing entries: Even though the Transfer balance sheet account 1. Transfer net income (or loss) to Retained balances carry Earnings. Earnings. forward from period to period, the income 2. Establish a zero balance Establish statement accounts do in each of the temporary temporary not. accounts to start the next accounting period. accounting 4-28 Closing the Books The following accounts are called temporary or nominal accounts and are closed at the end of the period . . . • Revenues. Revenues. • Expenses. Expenses. • Gains. Gains. • Losses. Losses. • Dividends declared. Dividends 4-29 Closing the Books Two steps are used in the Two closing process . . . closing 1. Close revenues and gains Close to Retained Earnings. to 2. Close expenses and losses Close to Retained Earnings. to 4-30 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. 4-31 ...
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