Adjustments, Financial Statements, and the Quality of Earnings

Adjustments, Financial Statements, and the Quality of Earnings Chapter 4 McGraw-Hill/Irwin 2009 The McGraw-Hill Companies, Inc.

Understanding the Business Management is responsible for preparing... Financial statements have formal guidance in preparation and presentation Publicly-traded firms Privately held firms Non-profit firms Financial Statements Financial statements have targeted audiences for standard distribution Publicly-traded firms Privately held firms Non-profit firms McGraw-Hill/Irwin Slide 2

Understanding the Business Management is responsible for preparing... Financial Statements High Quality = Relevance + Reliability... Are useful to investors and creditors. McGraw-Hill/Irwin Slide 3

Accounting Cycle Start of Period During the period: Analyze transactions. Record journal entries. Post amounts to general ledger. Close revenues, gains, expenses, and losses to Retained Earnings. At the end of the period: Adjust revenues and expenses. Prepare financial statements. Disseminate statements to users.

Purpose of Adjustments Revenues are recorded when earned. Expenses are recorded when incurred. Matching Principle Because transactions occur over time, ADJUSTMENTS are required at the end of each fiscal period to get the revenues and expenses into the right period. McGraw-Hill/Irwin Slide 5

Matching Principle A natural link (cause and effect) exists between revenues and some types of expenses Sales commissions (percentage of collected sales) Cost of goods sold (if sales = $0, costs = $0) Some expenses are not linked with sales but with a particular time period Rent expense Salary expense (monthly or hourly 3-6

Adjustment Process Adjusting entries can be grouped into three basic categories: Deferrals (revenue or expense into future period) An adjustment of an asset or a liability for which the business paid or received cash in advance Accruals (revenue or expense into current period) The recording of an expense or a revenue before paying or receiving cash Depreciation The systematic allocation of the cost of a plant asset to expense over the asset s useful life McGraw-Hill/Irwin Slide 7

Types of Adjustments There are four types of adjustments. Revenues 1. Unearned Revenues. 2. Accrued Revenues. Expenses 3. Prepaid Expenses. 4. Accrued Expenses. McGraw-Hill/Irwin Slide 8

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.

Trial Balance The trial balance Is a list of all accounts with their balances Assets first, followed by liabilities and then stockholders equity Aids in the preparation of the financial statements by summarizing all the account balances Provides a check on accuracy by showing whether total debits equal total credits McGraw-Hill/Irwin Slide 10

Matrix, Inc. Unadjusted Trial Balance At December 31, 2009 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, 12/31/08 1,760 total credits Sales revenue 35,000 Cost of goods sold 27,500 Operating expenses 6,300 Totals $ 57,385 $ 57,385 McGraw-Hill/Irwin Slide 11

Matrix, Inc. Unadjusted Trial Balance At December 31, 2009 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 10,000 is a contra-asset account. Retained earnings, 12/31/08 1,760 Sales revenue It is directly related to an 35,000 Cost of goods sold asset account 27,500 but has the Operating expenses 6,300 opposite balance. Totals $ 57,385 $ 57,385 McGraw-Hill/Irwin Slide 12

Matrix, Inc. Unadjusted Trial Balance At December 31, 2009 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 Cost - Accumulated depreciation = Accounts payable 2,985 Notes payable BOOK VALUE. 4,000 Common stock 10,000 Retained earnings, 12/31/08 1,760 Sales revenue 35,000 Cost of goods sold 27,500 Operating expenses 6,300 Totals $ 57,385 $ 57,385 McGraw-Hill/Irwin Slide 13

Unearned Revenues End of accounting period. Cash received. Revenues earned. Example includes rent received in advance (an unearned revenue). McGraw-Hill/Irwin Slide 14

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. McGraw-Hill/Irwin Slide 15

Unearned Revenues After we post the entry to the T-accounts, the account balances look like this: Unearned Rent Revenue 12/31 750 12/1 3000 Bal. 2,250 Rent Revenue 12/31 750 Bal. 750 McGraw-Hill/Irwin Slide 16

Accrued Revenue End of accounting period. Revenues earned Cash received Example includes interest earned during the period (accrued revenue). McGraw-Hill/Irwin Slide 17

Accrued Revenue At December 31 st, 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 McGraw-Hill/Irwin Slide 18

Prepaid Expenses End of accounting period. Cash paid. Expense incurred. Examples include prepaid rent, advertising, and insurance. McGraw-Hill/Irwin Slide 19

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 31 st, Matrix must recognize the portion of the insurance that has been consumed and becomes an expense. $3,600 1/3 = $1,200 per year. McGraw-Hill/Irwin Slide 20

Prepaid Expenses After we post the entry to the T-accounts, the account balances look like this: Prepaid Insurance Expense 1/1 3,600 12/31 1,200 Bal. 2,400 Insurance Expense 12/31 1,200 Bal. 1,200 Remaining two years of insurance at $1,200 per year. McGraw-Hill/Irwin Slide 21

Accrued Expenses End of accounting period. Expense incurred. Expense paid. Examples include accrued rent, accrued interest, and accrued wages. McGraw-Hill/Irwin Slide 22

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 JOURNAL Date Description Debit Credit Dec 31 Wages What Expense Should Denton's 50,000? Wages Entry Be Payable on 12/31/04? 50,000? McGraw-Hill/Irwin Slide 23

Accrued Expenses After we post the entry to the T-accounts, the account balances look like this: As of 12/27 Wages Expense $1,900,000 12/31 50,000 Bal. $1,950,000 Wages Payable 12/31 50,000 Bal. 50,000 McGraw-Hill/Irwin Slide 24

Accrued Expenses Involving Estimates Certain circumstances require adjusting entries to record accounting estimates. Examples include... Depreciation Bad debts Income taxes

Depreciation 13. Property and Equipment Property and equipment are recorded at cost, less accumulated depreciation. Depreciation is computed using the straight-line method over estimated useful lives or lease term if shorter. We amortize leasehold improvements purchased after the beginning of the initial lease term over the shorter of the assets useful lives or a term that includes the original lease term, plus any renewals that are reasonably assured at the date the leasehold improvements are acquired. Depreciation expense for 2008, 2007 and 2006 was $1,804 million, $1,644 million and $1,509 million, respectively. For income tax purposes, accelerated depreciation methods are generally used. Repair and maintenance costs are expensed as incurred and were $609 million in 2008, $592 million in 2007 and $532 million in 2006. Facility pre-opening costs, including supplies and payroll, are expensed as incurred. Estimated Useful Lives Life (in years) Buildings and improvements 8-39 Fixtures and equipment 3-15 Computer hardware and software 4-7 Long-lived assets are reviewed for impairment annually and also when events or changes in circumstances indicate that the asset s carrying value may not be recoverable. No material impairments were recorded in 2008, 2007 or 2006 as a result of the tests performed. Bad debts We estimate future write-offs based on historical experience of delinquencies, risk scores, aging trends, and industry risk trends. Substantially all accounts continue to accrue finance charges until they are written off. Total accounts receivable past due ninety days or more and still accruing finance charges were $393 million at January 31, 2009 and $235 million at February 2, 2008. Accounts are written off when they become 180 days past due. Income taxes 22. Income Taxes We account for income taxes under the asset and liability method. We have recognized deferred tax assets and liabilities for the estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted income tax rates in effect for the year the temporary differences are expected to be recovered or settled.

Preparing Financial Statements 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. McGraw-Hill/Irwin Slide 27

Financial Statement Relationships Net The income increases statement retained is created earnings first (a net loss by determining decreases retained the difference earnings). Dividends between decrease revenues retained and expenses. earnings. DIVIDENDS Decrease RETAINED EARNINGS Increase NET INCOME = REVENUES EXPENSES McGraw-Hill/Irwin Slide 28

Financial Statement Relationships Contributed Capital and Retained Earnings make up Stockholders Equity. Increase STOCKHOLDERS EQUITY CONTRIBUTED CAPITAL RETAINED EARNINGS Increase NET INCOME = REVENUES EXPENSES McGraw-Hill/Irwin Slide 29

Financial Statement Relationships ASSETS STOCKHOLDERS = LIABILITIES + EQUITY Increase CONTRIBUTED CAPITAL RETAINED EARNINGS Increase NET INCOME = REVENUES EXPENSES McGraw-Hill/Irwin Slide 30

Papa John's International, Inc. and Subsidiaries Consolidated Statement of Income Month Ended January 31, 2007 (in thousands of dollars) Revenues: Restaurant sales revenue $ 66,000 Franchise fees revenue 4,730 Total revenues 70,730 Costs and expenses: Cost of sales 30,000 Salaries expense 16,000 General & administrative expenses 14,100 Depreciation expense 2,500 Total costs and expenses 62,600 Operating income 8,130 Other revenues and gains (expenses and losses) Investment income 1,070 Interest expense (550) Gain on sale of land 3,000 Income before income taxes 11,650 Income tax expense 3,961 Net income $ 7,689 The income statement contains revenues and expenses. Earnings Per Share (EPS) must be reported on the income statement. Earnings per share $ 0.23

Statement of Stockholders Equity Net income appears on the statement of stockholders equity as an increase in Retained Earnings. Papa John's International, Inc. and Subsidiaries Consolidated Statement of Stockholders' Equity For the Month Ended January 31, 2007 (in thousands of dollars) Contributed Capital Retained Earnings Stockholders' Equity Beginning balance $ 1,000 $ 147,000 $ 148,000 Stock Issuance 2,000 2,000 Net income 7,689 7,689 Dividends (3,000) (3,000) Ending balance $ 3,000 $ 151,689 $ 154,689 From the Income Statement McGraw-Hill/Irwin Slide 32

Balance Sheet - Assets Papa John's International, Inc. & Subsidiaries Consolidated Balance Sheet January 31, 2007 (in thousands of dollars) Assets Current Assets: Cash $ 43,900 Accounts receivable 20,030 Interest receivable 70 Supplies 22,000 Prepaid expenses 14,500 Other current assets 14,000 Total current assets 114,500 $396,000 cost $191,500 accumulated depreciation is equal to $204,500. Long-term investments 2,000 Property and equipment (net of accumulated depreciation of $191,500) 204,500 Long-term notes receivable 15,000 Intangibles 67,000 Other assets 17,000 Total assets $ 420,000 McGraw-Hill/Irwin Slide 33

Balance Sheet Liabilities & Stockholders Equity Papa John's International, Inc. & Subsidiaries Consolidated Balance Sheet January 31, 2007 (in thousands of dollars) Liabilities and stockholders' equity Current liabilities Accounts payable $ 39,000 Dividends payable 3,000 Accrued expenses payable 76,150 Income taxes payable 3,961 Total current liabilities 122,111 Unearned franchise fees 6,200 Notes payable 110,000 Other long-term liabilities 27,000 Total liabilities 265,311 From the Statement of Stockholders Equity. Stockholders' equity Contributed capital 3,000 Retained earnings 151,689 Total stockholders' equity 154,689 Total liabilities and stockholders' equity $ 420,000 McGraw-Hill/Irwin Slide 34

Focus on Cash Flows This statement is a categorized list of all transactions of the period that affected the Cash account. The three categories are... 1. Operating activities, 2. Investing activities, and 3. Financing activities. McGraw-Hill/Irwin Slide 35

Focus on Cash Flows Disclosures 1.Cash interest paid. 2.Cash income taxes paid. 3.A schedule of significant noncash investing and financing transactions. McGraw-Hill/Irwin Slide 36

Net Profit Margin Net Profit Margin indicates how effective management is at generating profit on every dollar of sales. Net Profit Margin = Net Income Net Sales Net profit margin for Papa John s for 2006 is: $63,375,000 $1,001,557,800 = 6.33% McGraw-Hill/Irwin Slide 37

Closing the Books Even though the balance sheet account balances carry forward from period to period, the income statement accounts do not. Closing entries: 1. Transfer net income (or loss) to Retained Earnings. 2. Establish a zero balance in each of the temporary accounts to start the next accounting period. McGraw-Hill/Irwin Slide 38

Example of the Closing Concept When you go to sleep at night. When you wake-up in the morning McGraw-Hill/Irwin Slide 39

Closing the Books The following accounts are called temporary or nominal accounts and are closed at the end of the period... Revenues. Expenses. Gains. Losses. Dividends declared. McGraw-Hill/Irwin Slide 40

Closing the Books Three steps are used in the closing process... 1. Close revenues and gains to Retained Earnings. 2. Close expenses and losses to Retained Earnings. 3. Close dividends to Retained Earnings (if listed) McGraw-Hill/Irwin Slide 41

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 Retained Earnings 144,000 1/31/07 66,000 Close Restaurant Sales Revenue 66,000 66,000 McGraw-Hill/Irwin Slide 42

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 Retained Earnings 30,000 144,000 66,000 Cost of Sales Restaurants 30,000 30,000 Close McGraw-Hill/Irwin Slide 43

Closing Entries Dec 31 Service Revenue 5,000 Retained Earnings 5,000 Dec 31 Retained Earnings 4,400 Cost of Goods Sold 1,000 Salary Expense 2,000 Supplies Expense 300 Depreciation Expense 200 Utilities Expense 400 Income Tax Expense 500 McGraw-Hill/Irwin Slide 44

Closing the Books Assume we have closed all other revenue and expense accounts, and that dividends declared are recognized in a separate dividend account, which is closed to Retained Earnings at the end of the period. Retained Earnings Close 30,000 144,000 1/1/07 Close 16,000 66,000 Close Close 7,000 4,730 Close Close 4,000 1,070 Close Close 2,000 3,000 Close Close 500 Close 600 Close 2,500 Close 550 Close 3,961 67,111 218,800 151,689 Ending Bal. McGraw-Hill/Irwin Slide 45

Post-Closing Trial Balance After all temporary accounts have been closed, we prepare a post-closing trial balance. Only assets, liabilities, and stockholders equity accounts will appear. All revenue, expense, gain and loss accounts will have a zero balance. McGraw-Hill/Irwin Slide 46

Ed s Accounting Advice Record ongoing transactions Post to ledger Prepare Trial Balance Record adjusting entries Prepare Adjusted Trial Balance Prepare financial statements Income Statement Statement of Stockholders Equity Balance Sheet Statement of Cash Flows Record closing entries Revenues set to zero Expenses set to zero Post-closing Trial Balance McGraw-Hill/Irwin Slide 47

Accruals and Deferrals: Judging Earnings Quality Companies that make relatively pessimistic estimates that reduce current income are judged to follow conservative financial reporting strategies, and experienced analysts give these reports more credence. These companies are viewed as having higher quality earnings. McGraw-Hill/Irwin Slide 48

End of Chapter 4 2008 The McGraw-Hill Companies, Inc.

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