Chapter 4 20/09/2012. Why Adjustments Are Needed. The Need for Adjustments. Adjustments. Types of Deferral Adjustments.

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1 Chapter 4 Adjustments, Financial Statements, and the Quality of Financial Reporting Adjustments: How, When and Why? Preparing the Adjusted Trial Balance Preparing Adjusted Financial Statements The Closing Process Copyright 2009 McGraw-Hill Ryerson Limited. All rights reserved. Why Adjustments Are Needed Accounting systems are designed to record most recurring daily transactions, particularly any involving cash. Problem: Cash is not always received or paid in the same period when the revenue is earned or when the expense is incurred. Solution: We record adjusting entries at the end of each period to get the amounts reported as revenues and expenses up to date. The Need for Adjustments Need up-to-date and complete information Adjustments are used to: Update amounts already recorded Include events that have occurred but haven t been recorded Examples?? Decrease assets:, prepaid amounts Increase liabilities: Interest owed on loan, hydro bill How? Journal entries at the end of each Adjustments Journal entries made at the end of every accounting period to ensure that revenues and expenses are recorded in the proper accounting period Deferrals update existing accounts Accruals record new amounts Which GAAP principles is this practice consistent with? Revenue recognition Matching principle period Adjusting Entries Two types of adjusting entries. Types of Deferral Adjustments DEFERRALS Receipts of assets or payments of cash in advance of revenue or expense recognition. ACCRUALS Revenues earned or expenses incurred that have not been previously recorded. Inventories Prepaid Rent Unearned Revenue Cost of Goods Sold Expense Rent Expense Sales Revenue (update amounts already recorded) (record new amounts) Notice: The B/S accounts and the I/S accounts get adjusted in OPPOSITE directions: A DECREASE in Assets An INCREASE in Expense LO 2 A DECREASE in Liabilities 4-6 An INCREASE in Revenues 1

2 Deferrals: Let s Practice E4-3 Types of Accrual Adjustments Interest Receivable Interest Revenue Rent Receivable Rent Revenue Taxes Payable Taxes Expense Shareholders Transaction Assets Liabilities Equity a. b. c. Net Revenues Expenses Income 4-7 Wages Payable Interest Payable Notice: Every accrual affects: Wages Expense Interest Expense An ASSET& REVENUE account, OR A LIABILITY and EXPENSE account Accruals: Let s Practice E4-4 Shareholders Transaction Assets Liabilities Equity a. b. Net Revenues Expenses Income How Adjustments are Made c To make each necessary adjustment, apply the following steps: 1. Obtain the current unadjusted balances in the pair of accounts to be adjusted Where do we get these balances? T-accounts / Ledgers / Unadjusted Trial Balance 2. Calculate the amount of the adjustment E.g. How much revenue is receivable? E.g. How much do we owe for rent, phone, salaries, etc. 3. the journal entry to make the adjustment Deferral Adjustment Example: Used Example: At the beginning of September, First Choice purchased hair supplies on account. During September, First Choice Haircutters used some of these hair supplies Let s see how to record the necessary adjustment Purchase of (Sept 1) : (+A) 630 Payable (+L) 630 Step 1: Obtain the current unadjusted balances of the pair of accounts to be adjusted On September 30: Unadj. Bal. 630 Desired Bal. 400 Expense Desired Bal Deferral Adjustment Example: Used Step 2: Calculate the amount of the adjustment At the end of September the salon manager counted the supplies and determined that $400 were left. That means that $230 of supplies were used. Unadj. Bal. 630 Desired Bal. 400 Expense Desired Bal. 230 Step 3: the journal entry to make the adjustment Expense (+E, -SE) 230 (-A)

3 Deferral Adjustment Example: Used After the entry, this is what the T-accounts look like: Adjustments: Let s Practice E4-6 Unadj. Bal Adj. Entry Desired Bal. 400 On September 30: CREDIT (-) Asset Account (B/S) On September 30: DEBIT (+) Expense Account (I/S) Expense Adj. Entry 230 Desired Bal Deferral Adjustment: Depreciation Depreciation: Process of allocating the cost of property and equipment (ASSETS) to the accounting periods in which they are used - (Matching Principle) The term depreciation = amortization Requires the use of a contra-account An account that is an offset to, or reduction of, another account NOTE: Amortization Market Value We don t adjust the asset account directly, we instead use the contra account Deferral Adjustment: Depreciation Depreciation expense-current period s depreciation(i/s) accumulated depreciation-running total of all depreciation expense taken to date (B/S). Depreciation Expense: account Accumulated Depreciation: account Example: To record this month s depreciation expense for a $24,000 asset with an expected life of 2 years: Amortiation Expense (+E, -SE) 1, Accumulated Amortization ( -A) 1,000 Amortization Notice: Amortization adjusting entry: 1) reduces the CV of the asset on the B/S 2) Increases amortization expense in the current period. Carrying value (CV) simply means the amount an asset or liability is reported at ( carried at ) in the financial statements. It is also known as net book value (NBV) or book value. (BV) Cost -Accumulated Amortization Deferral Adjustment Example: Gift Cards Gift cards - when redeemed, revenues must be recognized b/c the co. has fulfilled its obligation Entry to record gift card purchase: DR Cash (+A) CR Deferred(Unearned Rev) (+L) Entry to record gift card redemption: DR Deferred (Unearned Rev) (-L) CR Revenue (+R, +SE) Recall: Unearned (deferred) revenue is a liability Until it is earned: Then it becomes a revenue NBV

4 Accrual Adjustment Example: Interest Revenue On September 1, First Choice Haircutters Salon moved some cash into a GIC investment at the bank. The GIC will pay $120 interest on November 30 Step 1: Obtain the current unadjusted balances of the pair of accounts to be adjusted (at September 30) Interest Receivable Desired Bal Interest Revenue - Unadj. Bal. 40 Desired Bal. Step 2: Calculate the amount of the adjustment (at September 30) Interest Receivable Desired Bal. 40 Interest Revenue - Unadj. Bal. 40 Desired Bal. Accrual Adjustment Example: Interest Revenue Step 3: the journal entry to make the adjustment (at September 30) Interest Receivable (+A) 40 Interest Revenue (+R) 40 Examples of other events that require adjustments include: Interest expense incurred but not yet recorded Wages expense incurred but not yet recorded Income taxes incurred but not yet recorded Dividends declared but not yet recorded AND not yet paid! Summary: Rules for Adjusting Entries Adjustments: Let s Practice E Never involve cash 2. Must include one B/S a/c (A or L) AND 3. Must include one I/S a/c (rev or exp) 4. Occur at the end of the accounting period Adjustments: Let s Practice E4-10 Another look E4-21 Transaction Assets Liabilities Shareholders Equity Revenues Expenses Profit (Net Income) a. b. c. d. e. f. g

5 Quality of Adjusted Financial Statements Adjustments involve judgment the possibility exists that some will make poor judgments LO-3 honest but optimistic estimates -lead to a higher net income Company - aggressive earnings as lower quality influenced by management s optimism about the future. Overall, adjustments significantly improve the quality of financial statements by ensuring that revenues are recognized when they are earned and expenses are 4-25 recorded when incurred. The Accounting Process Analyze Transactions Post- Closing Trial Balance Closing Entries & Post Journal Entries & Post This is where we left off: We are now ready to check that our accounts balance, using an adjusted trial balance Financial Statements LO-4 Unadjusted Trial Balance Adjusting Entries & Post Adjusted Trial Balance 4-26 The Accounting Process Recall: This is an adjusted trial balance. It simply lists all account balances at period-end. It looks exactly like an unadjusted trial balance. It is NOT a F/S (B/S, I/S, SRE, CF) DR = CR before we proceed to F/S First Choice Haircutters Salon Adjusted Trial Balance As of September 30, 2007 LO-4 Left Right Cash $ 7, Receivable 200 Interest Receivable 40 Prepaid Rent 4,800 Prepaid Insurance 2,200 Furnishings & Equipment 60,000 Accumulated Depreciation $ 1,000 Payable 1,030 Unearned Revenues 125 Interest Payable 100 Wages Payable 960 Income tax Payable 690 Dividends Payable 500 Notes Payable 20,000 Contributed Capital 50,000 Retained Earnings - Dividends Declared 500 Haircut Revenue 15,675 Interest Revenue 40 Wages Expense 8,960 Utilities Expense 700 Advertising Expense 400 Expense 230 Rent Expense 2,400 Insurance Expense 200 Depreciation Expense 1,000 Interest Expense Income Tax Expense 690 Total $ 90,120 $ 90,120 Adjusted Financial Statements Using our trial balance we can prepare our financial statements Typically prepared in this order 1. Income statement 2. Statement of retained earnings 3. Balance sheet 4. Statement of cash flows 5. Notes to financial statements LO-5 Why this order? 4-28 Adjusted Financial Statements Why this order? LO-5 First Choice Haircutters Salon First Choice Haircutters Salon For the Month Ended September 30, 2007 At September 30, 2007 (in Cdn dollars) First Choice Haircutters (in Cdn dollars) Salon Revenues Haircuts $ Statement 15,675 of Retained Earnings Assets Current Assets Total Revenue For the 15,675 Month Ended September 30, 2007 Cash $ 7,300 (in Cdn dollars) 400 Operating Expenses Retained Earnings, September Wages Expense 8,960 Receivables 1 $ Net Income Utilities Expense 700 Prepaids 1,035 7,000 Advertising Expense Dividends Declared 400 Total Current Assets (500) 14,940 Expense Retained Earnings, 230 September Furnishings 30 & Equipment $ 535 $ 60,000 Rent Expense 2,400 Accumulated Depreciation (1,000) Insurance Expense 200 Furnishings & Equipment, net 59,000 Depreciation Expense 1,000 Total Assets $ 73,940 Total Operating Expense 13,890 Liabilities Operating Income 1,785 Current Liabilities Other Revenues (Expenses): Payable $ 1,030 Interest Revenue 40 Unearned Revenues 125 Interest Expense (100) Accrued Liabilities 2,250 Income Before Income Tax Expense 1,725 Total Current Liabilities 3,405 Income Tax Expense 690 Notes Payable 20,000 Net Income $ 1,035 Total Liabilities 23,405 Shareholders' Equity Contributed Capital 50,000 Retained Earnings 535 Total Shareholders' Equity ,535 Total Liabilities and Shareholders' Equity $ 73,940 Finally: The Closing Process Serves two purposes: 1. Transfer NI (loss) and dividends to R/E 2. Establish zero balances in all I/S and dividend accounts at the end of the period (e.g. month, quarter, year) At year end, closing entries are required to: Move balances out of temporary accounts to a permanent account: Retained earnings

6 We CLOSE the TEMPORARY accounts (balance = $0) Expenses Liabilities 20/09/2012 Closing Entries Three entries are needed: 1. Close all revenues and gains: DR rev and gain a/c and CR R/E 2. Close all expenses and losses: CR exp and loss a/c DR R/E 3. Close the dividend-declared account: CR dividends-declared and DR R/E Closing Process: Revenues Temporary Temporary (nominal) accounts track financial results for a limited period of Q17 time. Dividends Assets Permanent Permanent (real) accounts track financial results from year to year. Equity Closing Process: After posting these closing entries, all the income statement accounts and the dividend account will have a zero balance. Below is an example of how two accounts would look after posting the closing entries. Haircut Revenue 15,675 Adj. Bal. Closing Entry 15,675 - End. Bal. Wages Expense Adj. Bal. 8,960 8,960 Closing Entry End. Bal. - Post-Closing Trial Balance Final check to make sure that total debits equal total credits Temporary accounts should have a zero balance (Revenue=Expense=Gains=Losses= Dividends = $0) Ending balance in retained earnings is now up to date Final check that the left column still equals the right and that all temporary accounts have been closed. Contains only permanent accounts. Is the last step in the accounting process Comprehensive Problems: A & B Look at the Demonstration Cases. These are EXCELLENT, comprehensive review questions. Please attempt these problems on your own, before the midterm

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