ACCOUNTING NOTES CHAPTER 4 ADJUSTMENTS FINANCIAL STATEMENTS THE QUALITY OF EARNINGS UNDERSTANDING THE BUSINESS Managers are responsible for preparing financial statements that are useful to investors creditors and others Financial information is most useful for analyzing the past and predicting the future when it is considered by users to be of high quality Revenues are to be recorded when earned and expenses are to be recorded when incurred regardless of when cash receipts or payments occur ADJUSTING REVENUES AND EXPENSES Accounting Cycle Accounting cycle the process followed by entities to analyze and record transactions adjust the records at the end of the period prepare financial statements and prepare the records for the next cycle o During the accounting period transactions that result in exchanges between the company and other external parties are analyzed and recorded in the general journal in chronological order the related accounts are updated in the general ledger o The end of period steps that focus primarily on adjustments to record revenues and expenses in the proper period and too update the balance sheet accounts for reporting purposes Unadjusted Trial Balance Trial Balance a spreadsheet that lists the names of the T accounts in one column usually in financial statement order with their ending debit or credit balances in the next two columns Purpose of Adjustments Accounting systems are designed to record most recurring daily transactions particularly those involving cash Adjusting Entries entries necessary at the end of the accounting period to measure all revenues and expenses of that period so that o Revenues are recorded when they are earned o Expenses are recorded when they are incurred to generate revenue o Assets are reported at amounts that represent the probable future benefits remaining at the end of the period o Liabilities are reported at amounts that represent the probable future sacrifices of assets or services owed at the end of the period Adjusting entries are required every time a company wants to prepare financial statements for external users Types of Adjustments There are four types of adjustments and each of these involves two entries o One for the cash receipt or payment o One for recording the revenue or expense in the proper period through the adjusting entry Adjustment Process In analyzing adjustments at the end of the period there are three steps STEP1 Was revenue earned or an expense incurred that is not yet recorded If the answer is YES credit the revenue account or debit the expense account in the adjusting entry STEP2 was the related cash received or paid in the past or will it be received or paid in the future If cash was received in the past reduce liability account that was recorded when cash was received because some or all of the liability has been earned since then If cash will be received in the future increase the receivable account to record what is owed by others to the company If cash was paid in the past reduce asset account that was recorded in the past because some or the entire asset has been used since then If cash will be paid in the future increase the payable account to record what is owed by the company to others STEP3 compute the amount of revenue earned or expense incurred Sometimes the amount is given or known sometimes it must be computed and sometimes it must be estimated When a customer pays for goods or services before the company delivers them the company records the amount of cash received in a deferred or unearned revenue account o This unearned revenue is liability representing the company s promise to perform or deliver the goods or services in the future Because the cash that is owed for goods and services has not yet been received and the customers have no yet been billed the revenue that was earned has not been recorded Revenues that have been earned but have not yet been recorded at the end of the account period are accrued revenues There are two components when lending or borrowing money principal the amount loaned or borrowed and interest the cost of borrowing Unless told otherwise the interest rate on loans and borrowings is always given as an annual percentage Many assets are used over time to generate revenues including supplies buildings equipment prepaid insurance and prepaid rent These assets are deferred expenses previously acquired asses that need to be adjusted at the end of the accounting period to reflect the amount of expense incurred in using the asset to generate revenue Building and equipment accounts increase when the assets are acquired and decrease when they are sold However these assets are also used over time to generate revenue Contra Account accounts that are directly linked to another account but with an opposite balance o For Property Equipment the contra account for the total cost used to date is called the Accumulated Depreciation On the balance sheet the amount that is reported for P E is its net book value equals the ending balance in the P E account minus the ending balance in the Accumulated Depreciation account Accrued expenses are previously unrecorded expenses that need to be adjusted at the end of the accounting period to reflect the amount incurred and the related payable account The final adjusting journal entry is to record the accrual of incomes taxes that will be paid in the next quarter This requires computing adjusted pretax income Adjustments are required to record revenues and expenses in the proper period because the cash part of the transaction is at a different point in time In addition each adjustment entry always included one income statement account and one balance sheet account PREPARING FINANCIAL STATEMENTS Financial statements are interrelated that is the numbers from one statement flow into the next statement Balance sheet accounts are considered permanent indicating that they retain their balances from the end of one period to the beginning of the next Revenue expense gain and loss accounts are temporary accounts because their balances accumulate for a period but start with a zero balance at the beginning of the next period Another way of representing the relationship among the statements The income statement is prepared first because net income is a component of Retained Earnings You will note that earnings EPS ratio is reported on the income statement It is widely used in evaluating the operating performance and profitability of a company
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