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“FINANCIAL ACCOUNTING” by: Robert Libby, Patricia A. Libby, and Daniel G. Short (4th Ed.) Chapter 4 - The Adjustment Pr

“FINANCIAL ACCOUNTING” by: Robert Libby, Patricia A. Libby, and Daniel G. Short (4th Ed.) Chapter 4 - The Adjustment Process and Financial Statements. BUSINESS BACKGROUND 1. of a company

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“FINANCIAL ACCOUNTING” by: Robert Libby, Patricia A. Libby, and Daniel G. Short (4th Ed.) Chapter 4 - The Adjustment Pr

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  1. 1-4-4 “FINANCIAL ACCOUNTING”by: Robert Libby, Patricia A. Libby, and Daniel G. Short (4th Ed.)Chapter 4 - The Adjustment Process and Financial Statements BUSINESS BACKGROUND 1. of a company that are used by investors, creditors, and others. Management is responsible for the financial statements

  2. BUSINESS BACKGROUND - CONTINUED 2-4-4 2. The financial statement information should be and reliable (verifiable and unbiased). The result of this high quality information is useful in analyzing the past and predicting the future. 3. Following the revenue principle and the matching principle (recognize expenses when incurred to generate revenues) requires adjustments of revenue and expense accounts. 4. Measuring revenue and expense items requires managers to make estimates. 5. The adjusting entry process goes beyond the day-to-day bookkeeping function. It requires a great deal ofknowledge, judgment, and experience. As such, manipulation of income needs to be closely scrutinized. This is an ethical issue. 6. The closing processclears all temporary accounts to a zero balance so they are ready for the accumulation of amounts in the new period. relevant (timely) (recognition when earned)

  3. ADJUSTING REVENUES AND EXPENSES – LO 1, 2- THE ACCOUNTING CYCLE 3-4-4 1. During the period, transactions are analyzed, recorded in journals, and posted to the general ledger. 2.At the end of the period, accounts are analyzed, adjustments are determined, financial statements are prepared, and the books are closed.

  4. ADJUSTING REVENUES AND EXPENSES – LO 1, 2- UNADJUSTED TRIAL BALANCE 4-4-4 1. The first step at the end of the accounting cycle is to prepare an This is merely a listing of accounts (usually in financial statement order) and their balances. Debit balances are placed in the left money column and credit balances are placed in the right money column. A trial balance is a "try to balance". It is a schedule for internal purposes to test debit-credit equality. It is NOT a financial statement. 2. There are several reasons for an imbalance to exist. a. Journal entries did not balance. b. Posting errors occurred. c. Computing the balance of an account may have a calculation error. d. Account balances may have been copied incorrectly to the trial balance. “unadjusted” trial balance.

  5. ADJUSTING REVENUES AND EXPENSES – LO 1, 2- ANALYSIS OF ADJUSTING ENTRIES 5-4-4 1. Since accrual accounting requires that revenues be recognized when earned and expenses be matched to such revenues when incurred, adjusting entries are necessary at the end of the accounting cycle. A good analytical tool for considering adjustments is a timeline. 2. The two types of adjusting entries are and . Unearned revenues (deferred revenues) and prepayments (deferred expenses) are referred to as deferrals. a. The need for deferrals results from the fact that a transaction has previously been recorded. That is, cash has already flowed in a transaction (received for deferred revenue/paid for deferred expense). deferrals accruals

  6. ADJUSTING REVENUES AND EXPENSES – LO 1, 2- ANALYSIS OF ADJUSTING ENTRIES (CONTINUED) 6-4-5 b. It is necessary to "update" accounts that do not have proper balances at the end of the period. This is accomplished by referring to the original transaction entry and preparing a timeline to analyze the effects of the passage of time. c. There are two ways to analyze most deferrals. Determine the proper balance in a revenue or expense account (the income statement approach). Determine the proper balance in an asset or liability account (the balance sheet approach). Note that the adjusted ending balances of the affected accounts will be the same under either approach. d. With the analysis completed, the adjustment may be journalized and posted. However, in the real world, the actual journalizing and posting of adjusting entries will usually be delayed until the financial statements are "out the door".

  7. ADJUSTING REVENUES AND EXPENSES – LO 1, 2- ANALYSIS OF ADJUSTING ENTRIES (CONTINUED) 7-4-5 3. Revenues and expenses may need to be "accrued". a. The need for accruals results from the fact that earned revenues and incurred expenses may not have resulted from transactions. That is, cash has not yet flowed from an external transaction. b. It is necessary to "update" accounts that do not have proper balances at the end of the period. This is accomplished by computing what amounts should be entered into the accounts under consideration. c. Analyze the activities that have taken place. - Revenues that have been earned but are unrecorded. - Expenses that have been incurred but are unrecorded. 4. There are three steps necessary to complete the adjustment process. Step 1 - Determine whether the adjustment is to an existing unearned revenue or prepayment or to an unrecorded accrued revenue or expense. Step 2 - Compute the revenue earned or expense incurred up to the end of the accounting period. Step 3 - Record the adjusting journal entry.

  8. ADJUSTING REVENUES AND EXPENSES – LO 1, 2- PAPA JOHN’S ILLUSTRATION - UNEARNED REVENUES AND PREPAYMENTS 8-4-5 1. The result of completing the adjustment process for unearned revenues requires an increase to a revenue account and a decrease to a liability accounts for earning amounts previously received in cash but deferred (delayed) from recognition. An illustrated example includes fees received in advance of completing services or delivering goods. 2. The result of completing the adjustment process for prepayments requires an increase to an expense account and a decrease to an asset (or increase contra-asset) account for prepaid expense expiration. Illustrated examples include insurance expiration, rent expiration, supplies used, inventory sold, and depreciation of property and equipment.

  9. ADJUSTING REVENUES AND EXPENSES – LO 1, 2- PAPA JOHN’S ILLUSTRATION - ACCRUED REVENUES AND EXPENSES 9-4-6 1. The results of completing the adjustment process for accrued revenues increases a revenue account and increases an asset account for earnings amounts not yet received in cash. (An illustrated example includes franchise fees earned but cash is not yet received.) 2. The results of completing the adjustment process for accrued expenses requires an increase in an expense account and an increase in a liability account for expense incurred but not yet paid. (Illustrated examples include salaries incurred, income tax incurred, interest incurred, and utilities incurred but not paid.)

  10. PREPARING FINANCIAL STATEMENTS – LO 3, 4 10-4-6 1. Since the updated account balances are now available, financial statements can be prepared. A worksheet can be helpful to derive these updated balances. 2.Order of statement preparation due to certain relationships: a.First, the Income Statement is prepared since net income is needed for the Statement of Stockholders' Equity. b.Next, the Statement of Stockholders' Equity is prepared since ending retained earnings must be determined for the Balance Sheet. c. Then, the Balance Sheet is prepared. 3. Cash flow information can also be collected. 4. The frequency of financial statement preparation will depend on the company's needs. Typically, preparation of these statements is done monthly, quarterly and/or annually.

  11. PREPARING FINANCIAL STATEMENTS – LO 3, 4- INCOME STATEMENT 11-4-6 1. It presents (net loss) during the period. It is also referred to as the profit and loss statement or P & L. 2. For corporations, the income statement (or the notes thereto) must present earnings per share (EPS). For simple capital structures, it is calculated as follows: Net income available to common stockholders EPS = Average number of common shares outstanding revenues - costs - expenses - + gains - losses = net income

  12. PREPARING FINANCIAL STATEMENTS – LO 3, 4- STATEMENT OF STOCKHOLDERS’ EQUITY 12-4-6 1. It presents during the period. Beginning retained earnings + net income (or -net loss) - dividends = Ending retained earnings. If this were presented separately, it would be the statement of retained earnings. 2. It also presents during the period. Beginning contributed capital + stock issues - stock repurchases and retirements = Ending contributed capital. changes in retained earnings changes in contributed capital

  13. PREPARING FINANCIAL STATEMENTS – LO 3, 4- BALANCE SHEET 13-4-6 1. It presents (the accounting equation) at a point in time at the end of business on that date. This is also known as the Statement of Financial Position since it shows what the company owns, what the company owes, and the “residual” owners' equity on that date. Assets are presented in order of liquidity and liabilities are presented in order of due dates. Assets = Liabilities + Stockholders' Equity

  14. CLOSING THE BOOKS – LO 5- END OF THE ACCOUNTING CYCLE 14-4-7 1. are NOT closed at the end of the accounting cycle. They are permanent accounts whose balances carry over to the beginning of the next accounting period. These permanent accounts include assets, liabilities, and owners' equity accounts. They will only have zero balances as a result of transactions or adjusting entries. 2. ARE closed at the end of the accounting cycle. These temporary accounts include revenues, gains, expenses, costs, and losses from the income statement. Dividends declared accounts are also temporary accounts. These are accounts that accumulate amounts for the accounting period. They are then closed out so they are ready to start the accumulation process for the next accounting period. 3. In closing entries, if temporary accounts have debit balances, they will be "credited away". If they have credit balances, they will be "debited away". The offset in the closing entries is to retained earnings. Real accounts Nominal accounts

  15. CLOSING THE BOOKS – LO 5- POST-CLOSING TRIAL BALANCE 15-4-7 The last step at the end of the accounting period should be the preparation of a post-closing trial balance. After the closing entries are journalized and posted, a listing of the remaining (surviving) accounts and their balances is prepared for two reasons: 1. To make sure that debits equal credits to start the new accounting period. 2. To make sure no temporary account balances remain. That is, temporary accounts should have zero balances at this point.

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