Download Adjustments, Financial Statements, and the Quality of

Adjustments, Financial Statements, and the
Quality of Earnings
Chapter 4
McGraw-Hill/Irwin
© 2009 The McGraw-Hill Companies, Inc.
Accounting Cycle
Start of Period
During the period:
 Analyze transactions.
 Record journal entries.
 Post amounts to general
ledger.
At the end of the period:
 Adjust revenues and
expenses.

Close revenues, gains,
expenses, and losses to
Retained Earnings.

Prepare financial
statements.
Disseminate
statements to users.

Types of Adjustments
There are four types of adjustments.
Revenues
1. Unearned
Revenues.
Expenses
3. Prepaid
Expenses.
2. Accrued
Revenues.
4. Accrued
Expenses.
Unearned Revenues
End of
accounting period.
Cash received.
Revenues earned.
Example includes rent received in
advance (an unearned revenue).
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
Rent Revenue
12/31 750
12/1 3000
12/31 750
Bal. 2,250
Bal.
750
Accrued Revenue
End of
accounting period.
Revenues earned
Cash received
Example includes interest earned during the
period (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
Prepaid Expenses
End of
accounting period.
Cash paid.
Expense incurred.
Examples include prepaid rent, advertising,
and insurance.
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
After we post the entry to the T-accounts, the
account balances look like this:
Prepaid
Insurance Expense
1/1 3,600
Bal. 2,400
12/31 1,200
Insurance Expense
12/31 1,200
Bal. 1,200
Remaining two years of insurance
at $1,200 per year.
Accrued Expenses
End of
accounting period.
Expense incurred.
Expense paid.
Examples include accrued rent, accrued
interest, and accrued wages.
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.
GENERAL
GENERAL JOURNAL
JOURNAL
Date
Description
Date
Description
Dec
Expense
Dec 31
31 Wages
What
Should Denton's
Wages
Payable
Entry Be
on 12/31/04?
Debit
Debit
50,000
?
Credit
Credit
50,000
?
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. $1,950,000
Wages Payable
12/31 50,000
Bal. 50,000
Accrued Expenses Involving Estimates
• Certain circumstances require
adjusting entries to record accounting
estimates.
• Examples include . . .
–Depreciation
–Bad debts
–Income taxes
Depreciation
• A systematic and rational method of allocating
the cost of a fixed asset over its expected
period of benefit.
• Method of matching the cost of using a long
term asset to generate revenue in a given
period.
Calculating Depreciation
• Cost of asset: $100,000
• Salvage Value (what it will be worth at the end
of its useful life): $-0• Useful Life: 5 years
• How much of the asset should be expensed
each year?
Recording Depreciation
• Always Debit DEPRECIATION EXPENSE
• CREDIT: Accumulated Depreciation (a contra asset –
nets against the cost of the asset)
• Cost of asset LESS Accumulated Depreciation equals
BOOK VALUE of asset.
• Amount of Accumulated Depreciation accumulates
over the useful life of the asset so that at the end of
the assets useful life the Book Value is equal to the
Salvage Value.
Book Value over Assets Life
Year
Depreciation
Expense
Asset Cost
Accumulated
Depreciation
Book Value
Year 1
$20,000
$100,000
$20,000
$80,000
Year 2
$20,000
$100,000
$40,000
$60,000
Year 3
$20,000
$100,000
$60,000
$40,000
Year 4
$20,000
$100,000
$80,000
$20,000
Year 5
$20,000
$100,000
$100,000
$-0-
Book Value over Assets Life
Assume that the Asset Cost is Still $100,000, Useful life is still 5 years, but Salvage
Value is now $25,000.
Year
Depreciation
Expense
Asset Cost
Accumulated
Depreciation
Book Value
Year 1
$15,000
$100,000
$15,000
$85,000
Year 2
$15,000
$100,000
$30,000
$70,000
Year 3
$15,000
$100,000
$45,000
$55,000
Year 4
$15,000
$100,000
$60,000
$40,000
Year 5
$15,000
$100,000
$75,000
$25,000