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10e

Financial Accounting

chapter 4

Adjustments, Financial Statements, and the Quality of Earnings

Financial Accounting

Libby • Libby • Hodge

chapter

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Learning Objectives

After studying this chapter, you should be able to:

4-1 Explain the purpose of adjustments and analyze the adjustments necessary at the end of the period to update revenues and expenses and related balance sheet accounts.

4-2 Present an income statement with earnings per share, a statement of stockholders' equity, and a balance sheet.

4-3 Compute and interpret the total asset turnover ratio.

4-4 Explain the closing process.

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Management is responsible for preparing . . .

. . . useful to investors and creditors.

High Quality = Relevant + Faithful Representation

Financial Statements

Understanding the Business

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Managers are responsible for preparing financial statements that will be 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. High-quality information is information that is relevant (that is, material and able to influence users’ decisions) and a faithful representation of what is being reported (that is, complete, free from error, and unbiased in portraying economic reality).

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Learning Objective 4-1

4-1 Explain the purpose of adjustments and analyze the adjustments necessary at the end of the period to update revenues and expenses and related balance sheet accounts.

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Exhibit 4.1

The Accounting Cycle

Start of a New Period

During the Period

(Chapters 2 and 3)

1 Analyze transactions

2 Record journal entries in the general journal

3 Post amounts to the general ledger

At the End of the Period

(Chapter 4)

4 Prepare a trial balance to determine if debits equal credits

5 Adjust revenues and expenses and related balance sheet accounts (record in journal and post to ledger)

6 Prepare a complete set of financial statements and disseminate it to users

7 Close revenues, gains, expenses, and losses to Retained Earnings (record in journal and post to ledger)

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Here is another look at the accounting cycle, which we previewed in the last chapter. In this chapter, we examine the end-of-period steps that focus primarily on adjustments to record revenues and expenses in the proper period and to update the balance sheet accounts for reporting purposes.

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The Purpose of Adjustments

Revenues are recorded when earned (the revenue recognition principle).

Expenses are recorded when they are incurred to generate revenue (the expense recognition principle).

Assets are reported at amounts that represent the probable future benefits remaining at the end of the period.

Liabilities are reported at amounts that represent the probable future sacrifices of assets or services owed at the end of the period.

Companies wait until the end of the accounting period to adjust their accounts because doing so daily or weekly would be very costly and time-consuming.

Adjusting entries are required every time a company prepares financial statements

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How does the accounting system record revenues and expenses when one transaction is needed to record a cash receipt or payment and another transaction is needed to record revenue when it is earned or an expense when it is incurred? The solution to the problem created by such differences in timing is to record adjusting entries at the end of every accounting period so that

Revenues are recorded when earned (the revenue recognition principle).

Expenses are recorded when they are incurred to generate revenue (the expense recognition principle).

Assets are reported at amounts that represent the probable future benefits remaining at the end of the period.

Liabilities are reported at amounts that represent the probable future sacrifices of assets or services owed at the end of the period.

Companies wait until the end of the accounting period to adjust their accounts because doing so daily or weekly would be very costly and time-consuming. Adjusting entries are required every time a company prepares financial statements for external users.

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Exhibit 4.2

Four Types of Adjustments

Adjusting Entries that Increase Revenues:

• Deferred Revenues

Previously recorded liabilities that were created when cash was received in advance and that must be reduced for the amount of revenue actually earned during the period.

• Accrued Revenues

Revenues that have been earned but not yet recorded because cash will be received after the services are performed or goods are delivered.

Previously recorded assets, such as Prepaid Rent, Supplies, and Equipment, that were created when cash was paid in advance and that must be reduced for the amount of expense actually incurred during the period through use of the asset.

• Deferred Expenses

• Accrued Expenses

Expenses that have been incurred but not yet recorded because cash will be paid after the goods or services are used.

Adjusting Entries that Increase Expenses:

Period 1 End of Period 1 Period 2

Entry for cash receipt

Entry for cash payment

Revenue

earned

Revenue

earned

Expense

incurred

Expense

incurred

Adjusting

Entry

Adjusting

Entry

Adjusting

Entry

Adjusting

Entry

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There are four types of adjustments (two in which cash was already received or paid and two in which cash will be received or paid). Because of the timing of the cash receipts or payments, each of these types of adjustments involves two entries:

• One for the cash receipt or payment either before or after the end of the period.

• One for the adjustment to record the revenue or expense in the proper period (the adjusting entry).

ADJUSTING ENTRIES are entries necessary at the end of the accounting period to properly measure all revenues and expenses of that period.

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Three Steps in the Adjustment Process

Step 1: Ask – Was revenue earned or an expense incurred that is not yet recorded?

If YES, increase the revenue or expense account in the adjusting entry.

Step 2: Ask – 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, a liability account (deferred revenue) was recorded in the past → Now reduce the liability account and record revenue earned.

If cash will be received in the future → Increase the receivable account to record what is owed by others (creating an accrued revenue).

If cash was paid in the past, a deferred expense account (asset) was created → Now reduce the asset because some or all of the asset has been used.

If cash will be paid in the future → Increase the payable account to record what is owed by the company (creating an accrued expense).

Step 3: Compute the amount of revenue earned or expense incurred. Sometimes the amount is given or known, sometimes it must be computed, and sometimes the amount must be estimated.

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Step 1: Ask: Was revenue earned or an expense incurred that is not yet recorded?

If YES, then credit the revenue account or debit the expense account in the adjusting entry.

Step 2: Ask: 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, a deferred revenue (liability) account was recorded in the past → Now, reduce the liability account that was recorded when cash was received.

If cash will be received in the future → Increase the receivable account to record what is owed by others to the company (creating an accrued revenue).

If cash was paid in the past, a deferred expense account was created in the past → Now, reduce the asset account.

If cash will be paid in the future → Increase the payable account to record what is owed by the company to others (creating an accrued expense).

Step 3: 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.

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Summary of the Adjustment Process

When revenue is earned:

DEFERRED REVENUE

If cash was received and previously recorded, the adjusting entry is

Unearned Revenue (−L) …………… xx

Revenue (+R, +SE) ………………… xx

ACCRUED REVENUE

If cash will be received, the adjusting entry is

Receivable (+A) ……………………... xx

Revenue (+R, +SE) ……………….. xx

When expense is incurred:

DEFERRED EXPENSE

If cash was paid and previously recorded, the adjusting entry is

Expense (+E, −SE) ……………………. xx

Prepaid Expense (−A) …………… xx

ACCRUED EXPENSE

If cash will be paid, the adjusting entry is

Expense (+E, −SE) ……………………. xx

Payable (+L) ……………………..….. xx

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In summary, this is the pattern that results when the adjusting entry is recorded.

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Exhibit 4.4

Unadjusted Trial Balance

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Here is the unadjusted trial balance for Chipotle for the first quarter.

From a review of the unadjusted trial balance, we identify several accounts that may need an adjustment:

• One deferred revenue account:

Unearned Revenue representing the amount received from customers on gift cards. A portion may have been earned during the quarter.

• One accrued revenue:

Additional interest on investments may have been earned but not yet received by the end of the quarter.

• Four deferred expense accounts:

Supplies of food, beverage, and packaging were used during the period.

Prepaid Expenses relating to rent, insurance, and advertising paid in the past were partially used during the period.

Buildings were partially used during the period to generate revenue.

Equipment also was partially used during the period to generate revenue. Because buildings and equipment were used during the quarter, we must make an adjustment to reflect that in the Accumulated Depreciation account representing the cost of the buildings and equipment that has been allocated (used) in the past.

• Four accrued expenses:

Wages, utilities, interest on notes payable, and income taxes

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Deferred (Unearned) Revenues (1 of 2)

Was revenue earned that is not yet recorded? Yes. When customers redeemed their gift cards during the quarter, Chipotle provided food service. Therefore, Chipotle earned $52 in Restaurant Sales Revenue that is not yet recorded by the end of the quarter. Record an increase in the revenue account.

Was the related cash received in the past or will it be received in the future? In the past. The Unearned Revenue account was created when cash was received in the past. At the end of the quarter, there is a $106 balance in the account. However, it is too large because a portion of it has been earned. Therefore, record a decrease in the unearned revenue account for the amount earned.

Compute the amount of revenue earned. The amount of the revenue that was earned is $52. Record $52 in the adjusting journal entry.

Step 1

Step 2

Step 3

AJE 1 Unearned Revenue: Chipotle received cash last period from customers purchasing gift cards. During the first quarter of 2018, customers redeemed a portion of the gift cards for $52 in food service.

Assets = Liabilities + Stockholders’ Equity

Unearned revenue (-L) −52 Restaurant sales revenue (+R) +52

	Debit	Credit
(AJE 1) Unearned Revenue (-L)	52
Restaurant sales revenue (+R, +SE)		52

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We follow the three-step adjustment process outlined in Exhibit 4.3 to illustrate how to apply the process. For each of the following adjustments, we shorten the term adjusting journal entry to AJE for ease of labeling

Chipotle received cash last period from customers purchasing gift cards and recorded an increase in Cash and an increase in Unearned Revenue, a liability, to recognize the business’s obligation to provide future services to customers. During the first quarter of 2018, customers redeemed a portion of the gift cards for $52 in food service.

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− Restaurant Sales Revenue (R) +

− Unearned Revenue (L) +

106 Bal.

1,228 Bal.

1,280

(AJE 1) 52

52 (AJE 1)

Deferred (Unearned) Revenues (2 of 2)

AJE 1 Unearned Revenue – AJE 1 had the following effect on the general ledger account balances.

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We must compute the amount of revenue earned during the period. In this case, the Unearned Revenue that was earned as revenue is $52. The adjusting entry is to debit, or decrease, the liability Unearned Revenue and credit the revenue account Restaurant Sales Revenue by $52.

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Accrued Revenues

Was revenue earned that is not yet recorded? Yes. Investments earned an additional amount of interest during the quarter, but no interest revenue has yet been recorded. Therefore, revenue is understated in the current quarter. Record an increase in the revenue account.

Was the related cash received in the past or will it be received in the future? In the future. Chipotle will receive the cash from the interest revenue in the next quarter. Because cash will be received, a new account (a receivable) needs to be increased. Increase Interest Receivable.

Compute the amount of revenue earned. The amount of the revenue that was earned is given. Record $1 in the adjusting journal entry.

Step 1

Step 2

Step 3

AJE 2 Interest on Investments: Investments owned by Chipotle earned $1 in additional interest revenue for the quarter, but the cash will be received in the next quarter.

Assets = Liabilities + Stockholders’ Equity

Interest receivable +1 Interest Revenue (+R) +1

+ Interest Receivable (A) − − Interest Revenue (R) +

Bal. 0

(AJE 2) 1

1 Bal.

1 (AJE 2)

	Debit	Credit
(AJE 2) Interest receivable (+A)	1
Interest revenue (+R, +SE)		1

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Investments owned by Chipotle earned $1 in additional interest revenue for the quarter, but the cash will be received in the next quarter.

Sometimes companies perform services or provide goods (that is, earn revenue) before customers pay. Because the cash that is owed for these goods and services has not yet been received and the customers have not yet been billed, the revenue that was earned may not have been recorded. Revenues that have been earned but have not yet been recorded at the end of the accounting period are called accrued revenues.

The final step is computing the amount of revenue earned. Investments owned by Chipotle earned $1 in additional interest revenue for the quarter, but the cash has not yet been received. The adjusting journal entry is to record the Interest Receivable and Interest Revenue earned during the period.

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Deferred Expenses (1 of 7)

Many assets are used over time to generate revenues, such as:

Supplies

Buildings and equipment

Prepaid expenses (e.g., prepaid rent, prepaid insurance, prepaid advertising)

These assets are deferred expenses (that is, recording the expenses for using these assets is deferred to the future). At the end of every period, an adjustment must be made to record the amount of the asset that was used during the period.

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Many assets are used over time to generate revenues, including supplies, buildings, equipment, and prepaid expenses for rent, insurance, and advertising. These assets are deferred expenses (that is, recording the expenses for using these assets is deferred to the future). At the end of every period, an adjustment must be made to record the amount of the asset that was used during the period.

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Deferred Expenses (2 of 7)

Was expense incurred that is not yet recorded? Yes. Supplies were used during the quarter to generate revenue, but no entry has been made to record the amount used. Expenses are understated. Record an increase in the Supplies Expense account.

Was the related cash paid in the past or will it be paid in the future? In the past. Chipotle purchased supplies during the quarter and recorded the acquisition in the Supplies account. Some of these supplies have been used during the quarter, but no entry has been made yet to reduce the account. Assets are overstated. Record a decrease in the Supplies account.

Compute the amount of expense incurred. The easiest way to determine the dollar amount of supplies used is to add the dollar amount of supplies available at the beginning of the period plus any purchases made during the period, and then subtract the dollar amount of supplies remaining on hand at the end of the period.

Step 1

Step 2

Step 3

Computation of Supplies Expense

Beginning balance—Supplies $ 20

+ Purchases during quarter 370

Unadjusted balance at end of quarter 390

− Amount on hand at end of quarter (24)

Supplies used during quarter $ 366

AJE 3 Supplies: At the end of the quarter, Chipotle counted $24 in supplies on hand, but the Supplies account indicated an unadjusted balance of $390.

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Supplies include food, beverage, and paper products for Chipotle. At the end of the quarter, Chipotle counted $24 in supplies on hand, but the Supplies account indicated a balance of $390 (from the unadjusted trial balance in Exhibit 4.4). We need to adjust the Supplies account to its proper balance of $24.

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The balance of Supplies on the unadjusted trial balance is $390, which includes the beginning balance for the quarter ($20) and the purchases during the quarter ($370). With $24 remaining on hand, the amount of supplies used during the period is $366. Record $366 in the adjusting entry.

Assets = Liabilities + Stockholders’ Equity

Supplies −366 Supplies expense (+E) −366

+ Supplies (A) − + Supplies Expense (E) −

Bal. 390

366

366 (AJE 3)

Bal. 0

(AJE 3) 366

Deferred Expenses (3 of 7)

AJE 3 Supplies

	Debit	Credit
(AJE 3) Supplies Expense (+E, -SE)	366
Supplies (-A)		366

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The adjusting journal entry is to debit Supplies Expense for $366 and credit Supplies for the same amount.

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Deferred Expenses (4 of 7)

Was expense incurred that is not yet recorded? Yes. A portion of the rent, insurance and all of the advertising have been used during the quarter to generate revenue, but no entry has been made to record the amount used. Expenses are understated. Record an increase in the Rent Expense, Insurance Expense, and Advertising Expense.

Was the related cash paid in the past or will it be paid in the future? In the past. Chipotle prepaid rent, insurance, and advertising before and at the beginning of the quarter. These provided probable future benefits and were recorded as an asset Prepaid Expenses. Because a portion of these prepaid expenses were used during the quarter, but no entry has been made yet to reflect that, the Prepaid Expenses account is overstated. Record a decrease in Prepaid Expenses.

Compute the amount of expense incurred. For the Chipotle example, the computations are as follows:

Rent: $18 per month × 3 months in the quarter = $54 used

Insurance: $48 prepaid × (3 months in the quarter / 6 months of coverage) = $24 used

Advertising: All during the quarter = $4 used

Record a total of $82

Step 1

Step 2

Step 3

AJE 4 Prepaid Expenses: The Prepaid Expenses unadjusted account balance of $131 includes (1) $72 paid at the beginning of the quarter for rental of facilities at $18 per month, (2) $48 for insurance coverage for six months beginning January 1, 2018, and (3) $4 for advertising during the quarter.

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Among a few other items, the Prepaid Expenses unadjusted account balance of $131 includes

• $72 paid at the beginning of the quarter for rental of facilities at $18 per month,

• $48 for insurance coverage for six months beginning January 1, 2018, and

• $4 for advertising during the quarter.

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Deferred Expenses (5 of 7)

AJE 4 Prepaid Expenses

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Prepaid Expenses is an asset account that is reduce when the prepaid expenses were used during the period.

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Deferred Expenses (6 of 7)

Was expense incurred that is not yet recorded? Yes. The company used buildings and equipment during the first quarter of 2018. However, no expense has yet been recorded, so expenses are understated. Record an increase in the expense account, Depreciation Expense.

Was the related cash paid in the past or will it be paid in the future? In the past. Chipotle purchased buildings and equipment in the past to be used over several years. The acquisitions were recorded in the asset accounts, which maintain the historical cost of the assets. The amount to be used in the future (net book value) must now be reduced for the depreciation for the first quarter of 2018. Reduce the net book value by recording an increase in the contra-account Accumulated Depreciation.

Compute the amount of expense incurred. The property and equipment have been used to generate revenue for the quarter. Thus, we need to calculate one quarter of Depreciation Expense:

Depreciation expense for the quarter = $124 for the year (given) × 1/4 of the year

= $31

Step 1

Step 2

Step 3

AJE 5 Buildings and Equipment

Building and equipment, but not land, depreciate over time as they are used. Depreciation is the allocation of the cost of buildings and equipment over their estimated useful lives to the organization.

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Buildings and equipment accounts increase by the cost of the assets when they are acquired and decrease by the cost of the assets when they are sold. However, these assets also are used over time to generate revenue. Thus, a part of their cost should be recorded as an expense in the same period (following the expense recognition principle). Accountants say that buildings and equipment, but not land, depreciate over time as they are used (land does not depreciate or get used up in an accounting sense). In accounting, depreciation is an allocation of the cost of buildings and equipment over their estimated useful lives to the organization.

To keep track of the asset’s historical cost, the amount that has been used is not subtracted directly from the asset account. Instead, it is accumulated in a new kind of account called a contra-account. Contra-accounts are accounts that are directly linked to another account, but with an opposite balance. For Buildings and Equipment, the contra-account for the total cost used to date is called Accumulated Depreciation (noted in Exhibit 4.4). Accumulated Depreciation increases with the amount of depreciation expense for the period and decreases when an asset is sold for the portion used in prior periods. This is the first of several contra-accounts you will learn throughout the text. We will designate contra-accounts with an X in front of the type of account to which it is related. For example, this first contra-account will be shown as Accumulated Depreciation (XA).

Because assets have debit balances, Accumulated Depreciation has a credit balance. On the balance sheet, the amount that is reported for total property and equipment is its net book value (also called the book value or carrying value), which equals the ending balance in the Land, Buildings, and Equipment accounts (total cost of property and equipment) minus the ending balance in the Accumulated Depreciation account (used cost of buildings and equipment).

Calculate one quarter of Depreciation Expense:

Depreciation expense for the quarter = $124 for the year (given) × 1/4 of the year = $31

Depreciation is discussed in much greater detail in Chapter 8.

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Deferred Expenses (7 of 7)

AJE 5 Depreciation on Buildings and Equipment: The amount of annual deprecation expense was given in the problem as $124. The quarterly deprecation expense is $31.

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We debit Depreciation expenses and credit Accumulated depreciation by $31.

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Accrued Expenses (1 of 5)

Many expenses are incurred in the current period without being paid until the next period.

Common examples include:

Wages Expense for the wages owed to employees who worked during the period

Utilities Expense for the water, gas, and electricity used during the period

Interest Expense incurred on debt owed during the period

These accrued expenses accumulate (accrue) over time but are not recognized as expenses until the end of the period in an adjusting entry.

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Many expenses are incurred in the current period without being paid until the next period. Common examples include wages expense for the wages owed to employees who worked during the period, Utilities Expense for the water, gas, and electricity used during the period, and Interest Expense incurred on debt owed during the period.

These accrued expenses accumulate (accrue) over time but are not recognized as expenses until the end of the period in an adjusting entry.

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Accrued Expenses (2 of 5)

Was expense incurred that is not yet recorded? Yes. The company used employee labor near the end of the first quarter of 2018. However, no expense has yet been recorded, so expenses are understated. Record an increase in Wages Expense.

Was the related cash paid in the past or will it be paid in the future? In the future. Chipotle will pay the employees in the next quarter, but no liability has yet been recorded. Liabilities are understated. Record an increase in Wages Payable.

Step 1

Step 2

AJE 6 Wages: Chipotle’s employees earned $67 in wages for working two days at the end of the quarter. They will be paid in the next quarter.

Step 3

Compute the amount of expense incurred. The amount of wages owed to employees is given. Record $67 in the adjusting entry.

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Numerous expenses are incurred in the current period without being paid until the next period.

Chipotle’s employees earned $67 in wages for working two days at the end of the quarter. They will be paid in the next quarter.

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Accrued Expenses (3 of 5)

Was expense incurred that is not yet recorded? Yes. The company used borrowed funds during the quarter, but the interest expense has not yet been recognized. Expenses are understated. Record an increase in Interest Expense.

Was the related cash paid in the past or will it be paid in the future? In the future. Chipotle will pay interest on the debt in the future. Because cash is owed, a payable account needs to be increased. Record an increase in Interest Payable.

Step 1

Step 2

AJE 7 Interest on Debt: Chipotle had a balance of $78 in long-term notes payable from prior years and borrowed an additional $2 at the beginning of the quarter, for a total of $80 of interest-bearing debt obligations. The interest (5.0% rate) will be paid in the future.

Step 3

Compute the amount of expense incurred. Calculate interest owed using the following formula:

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Interest on Debt Chipotle had a balance of $78 in long-term notes payable from financing activities in prior years and borrowed an additional $2 at the beginning of the quarter, for a total of $80 of interest-bearing debt obligations. There are two components when borrowing (or lending) money: principal (the amount borrowed or loaned) and interest (the cost of borrowing or lending). The interest rate on Chipotle’s borrowings is 5.0 percent. Notes Payable (noncurrent) was recorded properly for the $80 in principal when the money was borrowed and does not need to be adjusted. The principal is still owed. However, interest expense is incurred by Chipotle over time as the borrowed funds are used during each quarter. Interest will be paid in the future according to the loan agreement.

Chipotle had $80 principal in interest-bearing debt for the first quarter (3 out of 12 months). Record $1 in the adjusting entry.

Principal × Annual Interest Rate × Fraction of Year (since last computation) = Interest for the Period

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Accrued Expenses (4 of 5)

Was expense incurred that is not yet recorded? Yes. Chipotle used the utilities during the first quarter but has not yet recorded the expense. Expenses are understated. Record an increase in Utilities Expense.

Was the related cash paid in the past or will it be paid in the future? In the future. Chipotle will pay next quarter the utility billed for usage in the first quarter. The liability is understated. Record an increase in Utilities Payable.

Step 1

Step 2

AJE 8 Utilities: Chipotle received a utility bill for $15 for usage during the quarter. The bill will be paid next quarter.

Step 3

Compute the amount of expense incurred. The amount of the utilities incurred in the first quarter is given. Record $15 in the adjusting entry.

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Utilities Most organizations receive utility bills after using utility services such as electricity, natural gas, and telephone. Chipotle received a utility bill for $15 for usage during the quarter. The bill will be paid next quarter.

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Accrued Expenses (5 of 5)

Was expense incurred that is not yet recorded? Yes. Chipotle incurred taxes on its quarterly income. Until an adjusting entry is recorded at the end of the period based on all adjusted revenues, gains, expenses, and losses, total expenses on the income statement are understated. Record an increase in Income Tax Expense.

Was the related cash paid in the past or will it be paid in the future? In the future. Income taxes from the first quarter are due by the end of the second quarter. So the liabilities on the balance sheet must be increased. Record an increase in Income Taxes Payable.

Step 1

Step 2

AJE 9 Income Taxes: The final adjusting entry is to record the accrual of $101 of income taxes that will be paid in the next quarter.

Step 3

Compute the amount of expense incurred. Income taxes are computed on pretax income after all other adjustments. Record $101 in the adjusting entry.

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Income Taxes The final adjusting entry is to record the accrual of income taxes that will be paid in the next quarter. This requires computing adjusted pretax income and applying the appropriate tax rate.

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Learning Objective 4-2

4-2 Present an income statement with earnings per share, a statement of stockholders' equity, and a balance sheet.

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Interconnections among Financial Statements

Balance Sheet accounts are permanent. They retain their balances from one period to the next

Revenue, expense, gain, and loss accounts are temporary. Their balances accumulate but start with a zero balance at the beginning of the next period.

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Before we prepare a complete set of financial statements, let’s update Chipotle’s trial balance to reflect the adjustments. This will provide us with the adjusted balances needed for the statements.

In terms of naming financial statements, most companies use the Statement of Stockholders’ Equity rather than the Statement of Retained Earnings. The Statement of Stockholders’ Equity explains the changes in Retained Earnings as well as changes in other Stockholders’ Equity accounts. Once we complete the adjusted trial balance, we can begin the process of preparing the financial statements. We know that we begin the process of preparing the financial statements with the Income Statement.

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Relationships among Financial Statements

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Prior to preparing closing entries (which we will explain later), we must prepare the Income Statement because income flows into the Statement of Stockholders’ Equity. The Statement of Stockholders’ Equity must be completed before we can prepare the Balance Sheet because stockholders’ equity is part of the Balance Sheet.

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Exhibit 4.5 Trial Balance Spreadsheet

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Let’s update Chipotle’s trial balance to reflect the adjustments illustrated in this chapter, providing us with the adjusted balances needed for the statements. The spreadsheet in Exhibit 4.5 has three sets of debit-credit columns: one for the unadjusted balances as shown in Exhibit 4.4, then the effects of the adjustments AJE 1 through AJE 9, and finally, the adjusted balances that are determined by adding or subtracting the adjustment across each row. Again, we note that the total debits equal the total credits in each of the sets. Also notice that nearly every revenue and expense account was adjusted and several new accounts were created during the adjustment process at the end of the period (e.g., Interest Receivable and Depreciation Expense). It is from these adjusted balances that we will prepare an income statement, a statement of stockholders’ equity (which includes a column for Retained Earnings), and a balance sheet.

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Income Statement

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The income statement is prepared first because net income is a component of Retained Earnings.

This is the income statement drawn from the adjusted trial balance. Refer back to the adjusted trial balance and trace the income statement numbers forward.

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Earnings per Share

You will note that the earnings per share (EPS) ratio is reported on the income statement. It is widely used in evaluating the operating performance and profitability of a company.

Earnings

per

Net income

Average number of shares of common stock outstanding during the period

The actual computation of EPS is quite complex. In this text, we simplify the earnings per share computation.

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EPS is the only ratio required to be disclosed on the statement or in the notes to the statements. The actual computation of the ratio is quite complex and appropriate for more advanced accounting courses. For this course, the denominator is the average number of shares outstanding (the number at the beginning of the period plus the number at the end of the period, divided by two).

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Statement of Stockholders’ Equity

From transaction (a) in Ch. 2

From the income statement

From transaction (f) in Ch. 2

On the balance sheet

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The final total from the income statement, net income, is carried forward to the Retained Earnings column of the statement of stockholders’ equity. To this, the additional elements of the statement are added. Dividends declared and an additional stock issuance are also included in the statement.

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Balance Sheet

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The balance sheet shows the assets, liabilities, and equity accounts. Also, notice that the contra-asset account, Accumulated Depreciation, has been subtracted from the property and equipment account to reflect net book value (or carrying value). It is called net property and equipment on the balance sheet. The ending balances for Common Stock, Additional Paid-In Capital, Treasury Stock, and Retained earnings from the Statement of Stockholders' Equity are included on the balance sheet.

Also recall that assets are listed in order of liquidity, and liabilities are listed in order of due dates. Current assets are those used or turned into cash within one year (as well as inventory). Current liabilities are obligations to be paid with current assets within one year. Chipotle’s management decided to present the balances at the end of 2017 and the balances at the end of the first quarter of 2018.

The total liabilities and stockholders’ equity is equal to total assets. The balance sheet is in balance. Notice that total stockholders’ equity on the balance sheet ties to the Statement of Stockholders’ Equity.

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FOCUS ON CASH FLOWS

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Cash Flows from Operations, Net Income, and the Quality of Earnings

Warning sign:

What if there is a significant difference between cash flow from operations and net income?

This could signal the existence of unusual

1) Deferrals

2) Allocations

3) Valuations

Analysts look for unusual deferrals and accruals when they attempt to predict future periods’ earnings.

Some users consider earnings of higher quality when the ratio of cash flows from operations divided by net income is greater.

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Recall from Chapter 1 that companies report cash inflows and outflows over a period in their statement of cash flows. This statement categorizes all transactions that affect cash into three categories: operating, investing, and financing activities.

Comparing the cash flow from operations to net income is important. We will discuss this comparison in more depth when we reach Chapter 12.

Many standard financial analysis texts warn analysts to look for unusual deferrals and accruals when they attempt to predict future period's earnings. They often suggest that wide disparities between net income and cash flow from operations are a useful warning sign. We often relate cash flows from operations to net income in assessing the quality of earnings. Some users consider earnings of higher quality when the ratio of cash flows from operations divided by net income is greater.

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Learning Objective 4-3

4-3 Compute and interpret the total asset turnover ratio.

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KEY RATIO ANALYSIS

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How efficient is management in using its resources to generate sales?

The higher the asset turnover is, the more efficient assets are being utilized to generate revenues.

Net Sales (or Operating Revenues)

Average Total Assets*

Total Asset

Turnover Ratio

*An average is computed as: (Beginning balance + Ending balance) ÷ 2

Total Asset Turnover Ratio

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The total asset turnover ratio measures the sales generated per dollar of assets. A high asset turnover ratio signifies efficient management of assets; a low asset turnover ratio signifies less efficient management. A company’s products or services and business strategy contribute significantly to its asset turnover ratio. However, when competitors are similar, management’s ability to control the firm’s assets is vital in determining its success. Stronger financial performance improves the asset turnover ratio.

Creditors and security analysts use this ratio to assess a company’s effectiveness at controlling both current and noncurrent assets. In a well-run business, creditors expect the ratio on a quarterly basis to fluctuate due to seasonal upswings and downturns. For example, as inventory is built up prior to a heavy sales season, companies need to borrow funds. The asset turnover ratio declines with this increase in assets. Eventually, the season’s high sales provide the cash needed to repay the loans. The asset turnover ratio then rises with the increased sales.

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Data Analytics

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The SEC Uses Big Data

The FRAud Group concentrates on detecting fraud and prosecuting corporations and individuals for violations involving false or misleading financial statements and disclosures

The SEC uses data analytics proactively

The FRAud Group relies on statistical modeling and other data tools to detect differences and potential fraud

In July 2013, the U.S. Securities and Exchange Commission formed the Financial Reporting and Audit Task Force (now called the FRAud Group)

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In July 2013, the U.S. Securities and Exchange Commission formed the Financial Reporting and Audit Task Force (now called the FRAud Group). FRAud Group concentrates on detecting fraud and prosecuting corporations and individuals for violations involving false or misleading financial statements and disclosures. The SEC uses data analytics to build a more proactive enforcement program. FRAud Group relies on statistical modeling and other data tools to analyze narratives in financial statements submitted to the SEC by public corporations to identify subtle differences in the tone and language that provide quantifiable measures of risk (and potential fraud).

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Learning Objective 4-4

4-4 Explain the closing process.

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Even though the balance sheet account balances carry forward from period to period, the income statement account balances DO NOT carry forward.

Closing entries:

Transfer net income (or loss) to Retained Earnings.

Establish a zero balance in each of the temporary accounts to start the accumulation in the next accounting period.

Closing the Books

Reminder: Temporary accounts are revenue, expense, gain, and loss accounts

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After all adjusting entries are recorded and posted to update the accounts and the financial statements are prepared, a closing process is needed as the last step in the accounting cycle to mark the end of the current period and the beginning of the next.

All balance sheet accounts are permanent (real) accounts. They are not reduced to a zero balance at the end of the accounting period. All balance sheet accounts are carried forward from one period to the next. For example, the ending Cash balance of the prior accounting period is the beginning Cash balance of the next accounting period.

On the other hand, revenue, expense, gain, and loss accounts are used to accumulate data for the current accounting period only; they are called temporary or nominal accounts.

At the end of each period, the balances in the temporary accounts are transferred, or closed, to the Retained Earnings account by recording a closing entry. A closing entry has two purposes:

To transfer the balances in the temporary accounts to Retained Earnings

To establish a zero balance in each of the temporary accounts

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Closing Entries (1 of 3)

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Here is the closing entry for a few accounts from Chipotle. Notice that revenue accounts are closed with a debit (to zero out the accounts), and expense accounts are closed with a credit (to close out these accounts). The difference between revenues and expenses is net income, and it is closed to Retained Earnings. In addition, all temporary accounts have a zero balance after the closing entry is complete. We have accomplished the two purposes of the closing process.

Companies may close income statement accounts to a special temporary summary account, called Income Summary, which is then closed to Retained Earnings.

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Closing Entries (2 of 3)

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Here is the closing entry for Chipotle at March 31, 2018, although most companies close their records only at the end of the fiscal year. These amounts are taken from the adjusted trial balance (Exhibit 4.5). Note that the $303 increase in Retained Earnings equals net income.

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Closing Entries (3 of 3)

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After the closing process is complete, all income statement accounts have a zero balance.

The ending balance in Retained Earnings now is up-to-date (matches the amount on the balance sheet) and is carried forward as the beginning balance for the next period.

As an additional step of the accounting information processing cycle, a post-closing trial balance should be prepared as a check that debits still equal credits and that all temporary accounts have been closed.

Post-Closing Trial Balance

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After the closing process is complete, all income statement accounts have a zero balance. These accounts are then ready for recording revenues and expenses in the new accounting period. The ending balance in Retained Earnings now is up-to-date (matches the amount on the balance sheet) and is carried forward as the beginning balance for the next period. As an additional step of the accounting information processing cycle, a post-closing trial balance should be prepared as a check that debits still equal credits and that all temporary accounts have been closed. The accounting cycle for the period is now complete.

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