Chapter 4

Adjustments, Financial
Statements, and the
Quality of Earnings
 4-2

Business Background

Revenues are Expenses are

recorded when recorded when
earned. incurred.
 4-3

Accounting Cycle

During the period: l Close revenues,

l Analyze transactions. gains, expenses, and
l Record journal entries. losses to Retained
l Post amounts to general Earnings.
ledger.

l Prepare financial
At the end of the period: statements.
l Adjust revenues and l Disseminate
expenses. statements to
users.
 4-4

Learning Objectives

Analyze the adjustments necessary at the end

of the period to update balance sheet and
income statement accounts.
 4-5

At the end of the accounting period, 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.

External Transactions Adjusting

Entries

Start of End of
Accounting Accounting
Period Period
 4-6

Adjusting Entries
There are two types of adjusting entries.

DEFERRALS ACCRUALS
Receipts of assets Revenues earned
or payments of or expenses
cash in advance incurred that have
of revenue or not been
expense previously
recognition. recorded.
 4-7

Adjusting Entries

End of
accounting period.

Deferrals: Accruals:
Cash received Revenues earned
Cash received
or paid. or
or paid.
expense incurred.
 4-8

Deferred Revenue

When cash is
received prior to
earning revenue by
delivering goods or
services, the
company records a
journal entry to
recognize
unearned revenue.
 4-9

Deferred Revenue

End of
accounting period.

Cash received. Revenues earned.

Example includes rent received in

advance (an unearned revenue).
 4-10

Deferred Revenue

On December 1, 2020, Tom’s Rentals received a check for

$3,000, for the first four months’ rent from a new tenant.
The entry on December 1, 2020, to record the receipt of
the prepaid rent payment would be . . .

GENERAL JOURNAL
Date Description Debit Credit
Dec 1 Cash 3,000
Unearned Rent Revenue 3,000

This is a LIABILITY account

 4-11

Deferred Revenue
Received
cash for rent
< 4-month prepayment of rent >

12/1/20 12/31/20 1/31/21 2/28/21 3/31/21

Year end
 4-12

Deferred Revenue

On December 31, 2020, 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 Debit Credit
Dec 31 Unearned Rent Revenue 750
Rent Revenue 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.
 4-13

Deferred Revenue

After we post the entry to the T-accounts, the

account balances look like this:

Unearned Rent
Revenue Rent Revenue
12/31 750 12/1 3000 12/31 750

Bal. 2,250 Bal. 750

 4-14

Accrued Revenues

When revenues are

earned but not yet
recorded at the end of
the accounting period
because cash changes
hands after the service is
performed or goods
delivered
 4-15

Accrued Revenue

End of
accounting period.

Revenues earned Cash received

Example includes interest earned

during the period (accrued revenue).
 4-16

Accrued Revenue

On October 1, 2020, 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, 2021. On December 31, 2020, Webb, Inc. must
make an entry for the interest earned so far.

GENERAL JOURNAL
Date Description Debit Credit
Dec 31 Interest Receivable
What Should Webb's ?150
Interest Revenue
Entry Be? ?150
$10,000 × 6% × 3/12 = $150
 4-17

Accrued Revenue

After we post the entry to the T-accounts, the

account balances look like this:

Interest
Receivable Interest Revenue
12/31 150 12/31 150

Bal. 150 Bal. 150

 4-18

Chart for Deferred and Accrued Revenues

Deferred Revenue Accrued Revenue

Cash (+A)
During the period Cash received before revenue earned None
Unearned revenue (+L)

Unearned revenue (-L) Revenue receivable (+A)

End of the period Company has earned revenue
Revenue (+R, + SE) Revenue (+R, +SE)

Cash (+A)
Next period Cash is received None
Revenue receivable (-A)
 4-19

Expenses

Now, we need
to look at
adjusting
entries for
expenses.
 4-20

Deferred Expense
 4-21

Deferred Expense

End of
accounting period.

Cash paid. Expense incurred.

Examples include prepaid rent, advertising,

and insurance.
 4-22

Deferred Expense

On January 1, 2021, 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, 2021, to record the policy on

Matrix’s books would appear as follows . . .

GENERAL JOURNAL
Date Description Debit Credit
Jan. 1 Prepaid Insurance Expense 3,600
Cash 3,600
This is an
account
 4-23

Deferred Expense

Paid cash for

insurance
< 3-year insurance policy >

1/1/21 12/31/21 12/31/22 12/31/23

Year end Year end Year end
 4-24

Deferred Expense

On December 31, 2021, 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 Page 365

Date Description Debit Credit
Dec 31 Insurance Expense 1,200
Prepaid Insurance Exp. 1,200

In effect, the prepaid asset goes down ,

while the expense goes up .
 4-25

Deferred Expense

After we post the entry to the T-accounts, the

account balances look like this:

Prepaid
Insurance Expense Insurance Expense
1/1 3,600 12/31 1,200 12/31 1,200

Bal. 2,400 Bal. 1,200

 4-26

Accrued Expenses
 4-27

Accrued Expenses

As of 12/27/21, Denton, Inc. had already paid $1,900,000 in

wages for the year. Denton pays its employees every
Friday. Year-end, 12/31/21, falls on a Wednesday. The
employees have earned total wages of $50,000 for
Monday through Wednesday of the week ending 1/02/22.

GENERAL JOURNAL
Date Description Debit Credit
What
Dec 31 Wages Should Denton's
Expense ?
50,000
Entry Be
Wages on 12/31/04?
Payable ?
50,000
 4-28

Accrued Expenses

After we post the entry to the T-accounts, the

account balances look like this:

Wages Expense Wages Payable

As of
12/27 $1,900,000 12/31 50,000
12/31 50,000 Bal. 50,000
Bal. $1,950,000
 4-29

Chart for Deferred and Accrued Expenses

Deferred Expense Accrued Expense

Prepaid asset (+A)
During the period Cash paid before expense incurred None
Cash (-A)

Expense (+E, -SE) Expense (+E, -SE)

End of the period Company must recognize expense
Prepaid asset ((-A) Liability (+L)

Liability (-L)
Next period Cash is paid after expense incurred None
Cash (-A)

Deferred Revenue Accrued Revenue

Cash (+A)
During the period Cash received before revenue earned None
Unearned revenue (+L)

Unearned revenue (-L) Revenue receivable (+A)

End of the period Company has earned revenue
Revenue (+R, + SE) Revenue (+R, +SE)

Cash (+A)
Next period Cash is received None
Revenue receivable (-A)
 4-30

Types of Adjustments

4-30
 4-31

Adjustments Involving Estimates

 Certain circumstances require

adjusting entries to record accounting
estimates.
 Examples include . . .

 Depreciation
 Bad debts

 Income taxes $$$

 4-32

Adjustments Involving Estimates

 Certain circumstances require

adjusting entries to record accounting
estimates.
 Examples include . . . Let’s look at the
adjustment for
 Depreciation
depreciation
 Bad debts expense.
 Income taxes
 4-33

Depreciation Adjustment

The accounting
concept of This is a “cost
depreciation involves allocation” concept,
the systematic and not a “valuation”
rational allocation of concept.
the cost of a long-
lived asset over
multiple accounting
periods it is used to
generate revenue.
 4-34

Depreciation Adjustment

The journal entry required is to debit

Depreciation Expense and to credit an account
called Accumulated Depreciation.

GENERAL JOURNAL Page 352

Date Description Debit Credit
Dec 31 Depreciation Expense $$$$
Accumulated Depreciation $$$$

This is called a Contra-Asset

account.
 4-35

Matrix, Inc.
Unadjusted Trial Balance
At December 31, 2021
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 is a contra-asset account. 10,000
Retained earnings, 12/31/20 1,760
Sales revenue
It is directly related to an 35,000
Cost of goods sold asset account but has the
27,500
Operating expenses opposite balance. 6,300
Totals $ 57,385 $ 57,385
 4-36

Matrix, Inc.
Unadjusted Trial Balance
At December 31, 2021
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, 12/31/20 1,760
Sales revenue 35,000
Cost of goods sold 27,500
Operating expenses 6,300
Totals
Which $
Number should be reported on BS? Why do 57,385 $ this57,385
we report way?
 4-37

Depreciation Adjustment

At January 31, 2021, Papa John’s trial balance showed Property

& equipment of $338,000 (all numbers in thousands) and
Accumulated depreciation of $83,000. For the period, Papa
John’s needs to record an additional $2,500 in depreciation.

GENERAL JOURNAL Page 352

Date Description Debit Credit
Jan 31 Depreciation
What Should
Expense
Papa John's 2,500
?
Accumulated
Entry Be on 1/31/01?
Depreciation 2,500
?
 4-38

Depreciation Adjustment

After we post the entry to the T-accounts, the

account balances look like this:

Depreciation Accumulated
Expense Depreciation
1/31 2,500 1/31 83,000
1/31 2,500
Bal. 2,500
Bal. 85,500
 4-39

Accounting Cycle

During the period: l Close revenues,

l Analyze transactions. gains, expenses,
l Record journal entries. and losses to
l Post amounts to general Retained
ledger.
Earnings.

At the end of the period: l Prepare financial

l Prepare unadjusted statements.
trial balance l Disseminate
l Adjust revenues and statements to
expenses. users.
l Prepare adjusted trial
balance
 4-40

Learning Objectives

Explain the purpose of a trial balance.

 4-41

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.
 4-42

Matrix, Inc.
Unadjusted Trial Balance
At December 31, 2021
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 Note that 4,000
Common stock total debits = 10,000
Retained earnings, 12/31/20 1,760
Sales revenue
total credits 35,000
Cost of goods sold 27,500
Operating expenses 6,300
Totals $ 57,385 $ 57,385
 4-43

The Unadjusted Trial Balance

If total debits 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.
 4-44

The Adjusted Trial Balance

SPENCER, INC.
Trial Balance
December 31, 2021 unadjusted adjustments adjusted
Description Debit Credit Debit Credit Debit Credit
Cash $ 3,900 $ 3,900
Accounts receivable 4,985 4,985
Inventory 3,300 3,300
Equipment 4,800 4,800
Accumulated depreciation - Equip. $ 1,440 $ 140 $ 1,580
Furniture and fixtures 6,600 6,600
Accumulated depreciation - furn. & fix. 2,200 2,200
Accounts payable 2,985 2,985
Notes payable 4,000 4,000
Common stock 10,000 10,000
Retained earnings, 12/31/20 1,760 1,760
Sales Revenues 35,000 35,000
Depreciation Expense 0 $ 140 $ 140
COGS 27,500 27,500
Operating Expenses 6,300 6,300
Totals $ 57,385 $ 57,385 $ 140 $ 140 $ 57,525 $ 57,525
 4-45

Accounting Cycle

During the period: l Close revenues,

l Analyze transactions. gains, expenses,
l Record journal entries. and losses to
l Post amounts to general Retained
ledger.
Earnings.

At the end of the period: l Prepare financial

l Prepare unadjusted statements.
trial balance l Disseminate
l Adjust revenues and statements to
expenses. users.
l Prepare adjusted trial
balance
 4-46

Learning Objectives

Present an income statement, statement of

stockholders’ equity, and balance sheet, and
statement of cash flow.
 4-47

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.

 4-48

Relationships of financials

4-48
 4-49

Preparing Financial Statements

4-49
 4-50

The income
statement contains
revenues and
expenses.

Earnings Per
Share (EPS) must
be reported on
the income
statement.
 4-51

Statement of Stockholders’ Equity

Net income appears on the statement of stockholders’
equity as an increase in Retained Earnings.

From the
Income
Statement
 4-52

Balance Sheet - Assets

Papa John's International, Inc. & Subsidiaries
Consolidated Balance Sheet
January 31, 2021
(in thousands of dollars)
Assets
Current Assets:
Cash $ 37,900
Accounts receivable 17,100
Supplies 12,000
Prepaid expenses 17,500
Other current assets 7,000
Total current assets 91,500

Long-term investments 9,000

Property and equipment (net of
accumulated depreciation of $151,500) 210,500
Long-term notes receivable 14,000
Intangibles 49,000
Other assets 13,000
Total assets $ 387,000
 4-53

Balance Sheet – Liabilities & Stockholders’

Equity
Papa John's International, Inc. & Subsidiaries
Consolidated Balance Sheet
January 31, 2021
(in thousands of dollars)
Liabilities and stockholders' equity
Current liabilities
Accounts payable $ 38,000
Dividends payable 3,000
Accrued expenses payable 55,660
Income taxes payable 3,899
Total current liabilities 100,559
Unearned franchise fees 6,200
Long-term notes payable 75,000
Other long-term liabilities 40,000
Total liabilities 221,759

Stockholders' equity
Contributed capital 3,000
Retained earnings 162,241
Total stockholders' equity 165,241
Total liabilities and stockholders' equity $ 387,000
 4-54

Statement of Cash Flows

 4-55

Statement of Cash Flows

 4-56

Accounting Cycle

During the period: l Close revenues,

l Analyze transactions. gains, expenses,
l Record journal entries. and losses to
l Post amounts to general Retained
ledger.
Earnings.

At the end of the period: l Prepare financial

l Prepare unadjusted statements.
trial balance l Disseminate
l Adjust revenues and statements to
expenses. users.
l Prepare adjusted trial
balance
 4-57

Learning Objectives

Explain the closing process.

 4-58

Closing the Books

Closing entries:
Even though the
balance sheet 1. Transfer net income (or
account balances loss) to Retained Earnings.
carry forward from 2. Establish a zero balance
period to period, the in each of the temporary
income statement accounts to start the next
accounts do not. accounting period.
 4-59

Closing the Books

The following accounts are called

or nominal accounts and are
closed at the end of the period . . .
 4-60

Closing the Books

 4-61

Closing the Books

o w t o
H
C lo s e
the
o o k s !
B
 4-62

Closing the Books

To close Papa John’s Restaurant Sales Revenue

account, the following entry is required:

Restaurant
Retained Earnings Sales Revenue
158,000 12/31/20 66,000
 4-63

Closing the Books

To close Papa John’s Restaurant Sales Revenue

account, the following entry is required:

GENERAL JOURNAL Page 365

Date Description Debit Credit
Jan 31 Restaurant Sales Revenue 66,000
Retained Earnings 66,000

Restaurant
Retained Earnings Sales Revenue
158,000 12/31/20 66,000 66,000
66,000 Close
 4-64

Closing the Books

If we close the Retained Earnings

other revenue 158,000
66,000
12/31/20
Close
accounts in a 3,800 Close
similar fashion, 1,000 Close
the retained 3,000 Close

earnings
account looks
like this . . .
 4-65

Closing the Books

To close Papa John’s Cost of Sales - Restaurants

account, the following entry is required:

Cost of Sales
Retained Earnings Restaurants
30,000
 4-66

Closing the Books

To close Papa John’s Cost of Sales - Restaurants

account, the following entry is required:

GENERAL JOURNAL Page 365

Date Description Debit Credit
Jan 31 Retained Earnings 30,000
Cost of Sales - Restaurants 30,000

Cost of Sales
Retained Earnings Restaurants
30,000 30,000 30,000 Close
 4-67

Closing the Books

Retained Earnings
If we close the Close 30,000 158,000 12/31/20
other expense Close 16,000 66,000 Close
Close 7,000 3,800 Close
accounts in a Close 4,000 1,000 Close
similar fashion, Close 2,000 3,000 Close
the retained Close 500
earnings Close 600
Close 2,500
account looks Close 60
like this . . . Close 3,899
 4-68

Closing the Books

Retained Earnings
Close 30,000 158,000 12/31/20
Finally, we close
Close 16,000 66,000 Close
dividends to Close 7,000 3,800 Close
Retained Close 4,000 1,000 Close
Earnings. Close 2,000 3,000 Close
Close 500
Dr: Retained Earnings Close 600
Cr: Dividends Close 2,500
Close 60
Close 3,899
Close 3,000
162,241 Ending Bal.
 4-69

Post-Closing Trial Balance

Let’s take a look at the adjusted trial balance of

Matrix, Inc. at December 31, 2021. We want to
see the difference between the adjusted trial
balance and the post-closing trial balance.
 4-70

Post-Closing Trial Balance

Matrix, Inc.
Adjusted Trial Balance
At December 31, 2021
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, 12/31/20 1,760
Sales revenue 35,000
Cost of goods sold 27,500
Operating expenses 6,300
Totals $ 57,385 $ 57,385
 4-71

Post-Closing Trial Balance

Matrix, Inc.
Post-Closing Trial Balance
At December 31, 2021
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, 12/31/21 2,960
Sales revenue -
Cost of goods sold -
Operating expenses -
Totals $ 23,585 $ 23,585
 4-72

Learning Objectives

Compute and interpret the total asset

turnover ratio.
 4-73

Key Ratio Analysis

Asset Sales (or Operating) Revenues

Turnover =
Ratio Average Total Assets
 4-74

Financial Analysis
 2020 2021
 TA $396,000 $372,000
 Revenue $825,000 $945,000
 Asset turnover ratio for 2021?

 Competitor’s: 3.11
 Comments?
 4-75

End of Chapter 4

4
 4-76

1. Reading: Chapter 4
2. Adjusting Entries & Closing Entries
3. Accounting Cycle
Journalize -> Post to Ledger -> Unadjusted Trial
Balance -> Adjusting Entries -> Adjusted Trial
Balance -> Prepare Financial Statements ->
Closing Entries -> Post-closing Trial Balance
4. Net Profit Margin
 4-77

1. Adjusting entries typically affect the cash account

2. Deferred expenses are expenses that were paid for
after the usage of the goods or services.
3. Each adjusting entry affects at least one I/S account
and at least one B/S account.
4. Depreciation attempts to adjust the value of the assets
to reflect the market value of those assets on B/S.
5. An expense incurred, but not yet recorded nor paid,
creates an asset until the payment is made
 4-78

 Below are four transactions completed during 2021 by Timber

Lodge. The annual accounting period ends on December 31.
Each transaction will require an adjusting entry at December
31, 2021. Provide the journal entries for each transaction and
adjusting entries.

1. On July 1, 2021, Timber Lodge paid a two-year insurance

$8000 for a policy on its facilities.
2. On December 31, 2021 a tenant renting some storage space
from Timber Lodge had not paid the rent of $750 for December.
3. On September 1, 2021, Timber Lodge borrowed $25,000 cash
and gave a one-year, 10 percent, note payable. The total
interest of $2,500 is payable on the due date, August 31, 2022
4. On October 1, 2021, Timber Lodge collected $3,600 for rental
of space two years in advance.
 4-79

Income Statement
For the year ended Dec. 31, 2021
(in thousands of dollars)
Sales Revenue 35,200
Expenses
COGS 26,980
S,G&A 3,624
R&D expense 1,982
Interest expense 450
Total Expense 33,036
Pretax Income 2,164
Income Tax Expense 541
Net Income 1,623
Retained earnings, Dec. 31, 2020 132,231
Dividends in 2021 6,000