CH 4: Adjustments, Making Financial Statements & Closing

[Slides] Common misconception about accounting records

That records must be up-to-date and accurate at all times. That's not practical. For example, you would not record 1/30th of monthly rent revenue every day, or record the use of every pen, pencil, or sheet of paper. Instead, accounts are updated at the end of the period with adjusting entries.

[Slides] Three main types of journal entries

1) Exchange transaction entries: record exchanges of assets, goods, or services for assets, services, or promises to pay with other parties. 2) Adjusting entries: record revenues or expenses not yet recorded because there was no exchange transaction. 3) Closing entries: close revenues, gains, expenses, and losses to Retained Earnings and reset income statement accounts to zero for the next period.

[Slides] Periodicity and the "hard stop"

To prepare financial statements we need a "hard stop," which is the year end or quarter end. This concept is called periodicity. Adjusting entries make sure assets, liabilities, and equity are measured properly as of the hard stop, which also makes net income correct for the period.

[Slides] In general, what do adjusting entries record?

Revenues that have been earned but not recorded during the period, and expenses that have been incurred but not recorded during the period

[Slides] Four types of adjusting entries (seller vs. buyer)

DEFERRALS (cash received/paid first): Seller = Deferred (Unearned) Revenue, a liability. Buyer = Deferred (Prepaid) Expense, an asset. ACCRUALS (good/service provided or received first): Seller = Accrued Revenue (Receivables), an asset. Buyer = Accrued Expense (Payables), a liability.

[Slides] Why do we need adjusting entries?

Because the timing of cash is different from the timing of the revenue or expense

[Slides] Dual purpose goal of adjusting entries

1) Make sure assets, liabilities, and equity are properly valued at the end of the period. 2) Make sure revenues and expenses are properly reported on the income statement. So every adjusting entry affects at least one income statement account and at least one balance sheet account, but NEVER cash (cash was already recorded when it was received or paid).

[Slides] Deferred Revenue – initial entry and adjusting entry

Initial entry when cash is received: Dr Cash (+A) / Cr Unearned Revenue (+L). Adjusting entry when earned: Dr Unearned Revenue (−L) / Cr Revenue (+R, +SE). Example: Netflix collecting customers' annual membership fees.

[Slides] Exercise 4.1: Tippie's Rentals (12/31 year end) receives a $4,000 check on Dec 1, 20X1 for the first four months' rent. December journal entries?

12/1: Dr Cash 4,000 / Cr Unearned Rent Revenue 4,000. 12/31 adjusting entry (one month earned): Dr Unearned Rent Revenue 1,000 / Cr Rent Revenue 1,000

[Slides] Examples of deferred (unearned) revenue

Subscription revenue (streaming, magazines, software licenses), season tickets sold in advance, Costco membership fees, and first and last months' rent. Revenue is recorded, and deferred revenue decreased, when the good or service is provided. Adjusting entries record the portion earned by the end of the period.

[Slides] Accrued Revenue – adjusting entry and later cash entry

Adjusting entry: Dr Receivable (+A) / Cr Revenue (+R, +SE). When cash is received later: Dr Cash (+A) / Cr Receivable (−A). Example: interest earned from investments.

[Slides] Exercise 4.3: On Oct 1, 20X1, Hawkeye invests $10,000 in a 6-month CD paying 6% per year. Interest is received when the CD matures on Mar 31, 20X2. Entries?

12/31/X1 adjusting entry (3 months earned: $10,000 × 6% × 3/12): Dr Interest Receivable 150 / Cr Interest Revenue 150. 3/31/X2 (total interest $300): Dr Cash 300 / Cr Interest Receivable 150 / Cr Interest Revenue 150 (the Jan–Mar interest)

[Slides] Examples of accrued revenue

Rent earned but not yet received from tenants, utilities provided but not yet paid for by customers, and interest earned but not yet received from the bank. Cash is recorded and the receivable decreased when the customer pays.

[Slides] Exercise 4.4 (1): Amazon collected $100 million for annual Prime memberships on June 30, 20X3 and recorded "Deferred Prime Membership Fees." Adjustment on Dec 31, 20X3?

Yes. 6 of 12 months are earned: Dr Deferred Prime Membership Fees 50 million / Cr Membership Fee Revenue 50 million

[Slides] Exercise 4.4 (2): Bank of America earned $72.6 billion of interest evenly during 20X3 and collects interest on the 15th of each month. Adjustment on Dec 31, 20X3?

Yes. Interest for Dec 16–31 (half a month) is earned but not collected: $72.6B ÷ 12 = $6.05B per month, × ½ = $3.025B. Dr Interest Receivable 3.025 billion / Cr Interest Revenue 3.025 billion

[Slides] Deferred (Prepaid) Expense – initial entry and adjusting entry

Initial entry when cash is paid: Dr Prepaid Expense (+A) / Cr Cash (−A). Adjusting entry when used: Dr Expense (+E, −SE) / Cr Prepaid Expense (−A). Example: purchasing supplies. Expenses are recorded in the period they are used to earn revenue.

[Slides] Accrued Expense – adjusting entry and later cash entry

Adjusting entry: Dr Expense (+E, −SE) / Cr Payable (+L). When cash is paid later: Dr Payable (−L) / Cr Cash (−A). Example: utilities used during the month.

[Slides] Exercise 4.5: Pappajohn (12/31 year end) pays $3,600 on Jan 1, 20X1 for a 3-year fire insurance policy. 20X1 journal entries?

1/1/X1: Dr Prepaid Insurance 3,600 / Cr Cash 3,600. 12/31/X1 (1 year used up: $3,600 ÷ 3): Dr Insurance Expense 1,200 / Cr Prepaid Insurance 1,200

[Slides] Depreciation (definition)

The allocation of the cost of equipment (or buildings) over its period of use. It is a prime example of a deferred expense: the asset (PP&E) is recorded at purchase, then depreciation expense is recorded over time as the asset is used to generate revenue.

[Slides] Depreciation – original entry and adjusting entry

Original entry (cash paid in advance of use): Dr Plant and Equipment (+A) / Cr Cash (−A). Adjusting entry (value used up this year): Dr Depreciation Expense (+E, −SE) / Cr Accumulated Depreciation (+XA)

[Slides] Contra-asset, and why we credit Accumulated Depreciation instead of Plant & Equipment

A contra-asset (XA) is paired with a regular asset like Plant or Equipment and reduces it. We credit Accumulated Depreciation to provide MORE INFORMATION: the balance sheet shows both the original cost and how much has been used up.

[Slides] Airline example: A has $10M gross airplanes and $8M accumulated depreciation. B has $3M gross and $1M accumulated depreciation. Both have $2M net. What proportion of life is used up?

Airline A: about 80% used up ($8M ÷ $10M). Airline B: about 33% used up ($1M ÷ $3M). Same net amount, but A's planes are much older. This is why the contra-asset provides useful information.

[Slides] Concept Review: What type of adjusting entry is recorded when a company has PAID cash but not yet RECEIVED a good or service?

Deferred expense (prepaid expense, an asset)

[Slides] Concept Review: What type of adjusting entry is recorded when a company has PROVIDED a good or service but not yet RECEIVED cash?

Accrued revenue (a receivable, an asset)

[Slides] Concept Review: What type of account is Depreciation Expense? What type is Accumulated Depreciation?

Depreciation Expense is an expense (income statement, temporary, increases with a debit). Accumulated Depreciation is a contra-asset (balance sheet, permanent, increases with a credit).

[Slides] Exercise 4.7 (1): Southwest Airlines has $25,202 million of aircraft with a 25-year useful life. Adjusting entry on Dec 31, 2024?

Yes, depreciation must be recorded: $25,202M ÷ 25 ≈ $1,008 million. Dr Depreciation Expense 1,008 / Cr Accumulated Depreciation 1,008 (in millions)

[Slides] Exercise 4.7 (2): At the end of FY 2024, The Gap had $31 million of prepaid rent covering FY 2025 (annual leases). Adjusting entry to recognize rent expense?

Not at the end of FY 2024, because none of the rent has been used yet, so it stays a current asset. At the end of FY 2025 the rent is used up: Dr Rent Expense 31 / Cr Prepaid Rent 31 (in millions)

[Slides] Exercise 4.8: Kinnick (12/31 year end) buys equipment on 1/1/X1 for $5,000, 5-year life, no salvage value. 20X1 entries?

1/1/X1: Dr Plant and Equipment (+A) 5,000 / Cr Cash (−A) 5,000. 12/31/X1: Dr Depreciation Expense (+E, −SE) 1,000 / Cr Accumulated Depreciation (+XA) 1,000 ($5,000 ÷ 5 years)

[Slides] Exercise 4.8: Kinnick's ending T-account balances for 20X1

Plant & Equipment (gross): 0 + 5,000 purchases = 5,000. Accumulated Depreciation: 0 + 1,000 depreciation = 1,000. Plant & Equipment (net): 0 + 5,000 − 1,000 = 4,000. Gross P&E decreases for disposals; net P&E decreases for depreciation and the net book value of disposals.

[Slides] Chipotle trial balance spreadsheet (Q1 2018, in millions) – layout

Three sets of columns: Unadjusted (6,765 = 6,765), then Adjustments (716 = 716), then Adjusted (6,981 = 6,981). Cash stays at 731 in both columns because cash is never adjusted. After the adjusting entries, the trial balance is updated and the financial statements are prepared.

[Slides] Chipotle's 9 adjusting entries (Q1 2018, in millions)

AJE1: Unearned Revenue −52, Restaurant Sales Revenue +52. AJE2: Interest Receivable / Interest Revenue 1. AJE3: Supplies Expense / Supplies 366. AJE4: Prepaid Expenses −82 (Rent Exp 54, Insurance Exp 24, Advertising Exp 4). AJE5: Depreciation Exp / Accumulated Depreciation 31. AJE6: Wages Exp / Wages Payable 67. AJE7: Interest Exp / Interest Payable 1. AJE8: Utilities Exp / Utilities Payable 15. AJE9: Income Tax Exp / Income Taxes Payable 101.

[Slides] Order of preparing financial statements and how they connect

1) Income Statement first. 2) Net income flows to the Statement of Stockholders' Equity (added to Retained Earnings). 3) Ending stockholders' equity flows to the Balance Sheet (Assets = Liabilities + SE).

[Slides] Statement of Stockholders' Equity structure

Common Stock & APIC: Beginning + Stock issuances − Stock repurchases = Ending. Retained Earnings: Beginning + Net income − Dividends = Ending. Total: Beginning + issuances − repurchases + net income − dividends = Ending.

[Slides] Chipotle Statement of Stockholders' Equity (quarter ended 3/31/2018, in millions)

Beginning total SE $1,365 + stock issuance $300 (CS $1, APIC $299) + net income $303 (from the income statement) − dividends $2 = Ending $1,966. Ending balances: CS $2, APIC $1,604, Treasury Stock ($2,334), Retained Earnings $2,694.

[Slides] Chipotle Balance Sheet (3/31/2018, in millions)

Total current assets $1,192. P&E cost $2,360 − accumulated depreciation $1,010 = net $1,350. Total assets $2,658. Total current liabilities $333, total liabilities $692, total SE $1,966 (from the Statement of SE). Total liabilities + SE = $2,658.

[Slides] Permanent vs. Temporary accounts (slides)

Permanent accounts are balance sheet accounts and keep their balances from one period to the next. Temporary accounts are revenue, expense, gain, and loss accounts. Their balances accumulate during the period but start at zero at the beginning of the next period.

[Slides] Closing journal entries – objective and why

Objective: move the balances in the income statement accounts to Retained Earnings and reset them to zero. Why: so Retained Earnings on the balance sheet is up to date at period end, and so income statement accounts are ready for the new period.

[Slides] Steps for closing journal entries

1) Debit all Revenues and Gains for their full balance. 2) Credit all Expenses and Losses for their full balance. 3) The difference is a debit or credit to Retained Earnings that makes the entry balance.

[Slides] Closing entry when the firm has NET INCOME (Revenues > Expenses)

Dr Revenues & Gains (−R, −SE) / Cr Retained Earnings (+SE) / Cr Expenses & Losses (−E, +SE). The credit to Retained Earnings equals net income.

[Slides] Closing entry when the firm has a NET LOSS (Revenues < Expenses)

Dr Revenues & Gains (−R, −SE) / Dr Retained Earnings (−SE) / Cr Expenses & Losses (−E, +SE). The debit to Retained Earnings equals the net loss.

[Slides] Closing entry example: Sales Revenue 1,100,000, Interest Revenue 21,000. Expenses: Wages 369,000, Rent 244,500, Supplies 66,000, Depreciation 31,500, Loss on Disposal 4,250, Interest 1,200, Income Tax 140,500

Dr Sales Revenue 1,100,000 and Dr Interest Revenue 21,000. Cr each expense and loss for its balance (total 856,950). Cr Retained Earnings 264,050 (= net income: 1,121,000 − 856,950)

[Slides] T-account closing example: Sales Revenue 10,000, COGS 4,700, Advertising Expense 800. What is the missing line (???) in the closing entry?

Cr Retained Earnings 4,500 (= net income: 10,000 − 4,700 − 800). Full entry: Dr Sales Revenue 10,000 / Cr COGS 4,700 / Cr Advertising Expense 800 / Cr Retained Earnings 4,500. All three accounts end at zero.

[Slides] Concept Review: What type of entry moves revenues, gains, expenses, and losses to Retained Earnings and resets income statement accounts to zero?

Closing entries

[Slides] Concept Review: The debit or credit to Retained Earnings in a closing entry equals what?

Net income (credit to RE) or net loss (debit to RE)

[Slides] Exercise 4.9: In 20X2 Tippie Co. had Sales Revenue $1,000, COGS $500, Depreciation Expense $100. Prior year-end RE was $10,000. Net income and closing entry?

Net income = $400 (1,000 − 500 − 100). Closing entry: Dr Sales Revenue 1,000 / Cr Cost of Goods Sold 500 / Cr Depreciation Expense 100 / Cr Retained Earnings 400. RE rises to $10,400 (assuming no dividends).

[Slides] T-account inference

If we know the properties of an account, we can use a T-account to find missing values, many of which are not reported at all. Beginning balance + increases − decreases = Ending balance, then solve for the unknown.

[Slides] Hawkeye: Insurance expense was $75,000. Beginning Prepaid Insurance $12,000, ending $19,000. How much cash was paid for insurance?

$82,000. Prepaid Expense (A): Beginning 12,000 + Cash Paid − Expense Recognized 75,000 = Ending 19,000, so Cash Paid = 19,000 + 75,000 − 12,000

[Slides] Exercise 4.10: Carver collected $170,000 from tenants. Beginning Unearned Rent Revenue $10,000, ending $40,000. Rent revenue recognized?

$140,000. Unearned Revenue (L): Beginning 10,000 + Cash Received 170,000 − Revenue Recognized = Ending 40,000, so Revenue = 10,000 + 170,000 − 40,000

[Slides] Exercise 4.12: Pappajohn's Interest Receivable went from $10,000 (beginning) to $90,000 (ending). Which was larger, Interest Revenue or cash received for interest, and by how much?

Interest Revenue was larger, by $80,000. Accrued Revenue (A): Beginning 10,000 + Revenue Accrued − Cash Received = Ending 90,000, so Revenue − Cash = 80,000. The receivable grew because revenue earned exceeded cash collected.

[Textbook] Three purposes of adjusting entries (textbook)

To measure income properly, to CORRECT ERRORS, and to provide adequate valuation of balance sheet accounts

[Textbook] Contra-Account (general definition)

An account that is an offset to, or reduction from, the primary account or financial statement section. Accumulated depreciation is one example.

[Textbook] Net Book Value (Carrying Value or Book Value)

The acquisition cost of an asset less its accumulated depreciation, depletion (for natural resources), or amortization (for intangible assets)

[Textbook] Temporary Accounts – textbook detail

Income statement accounts, and sometimes Dividends Declared, that are closed to Retained Earnings at the end of the accounting period

[Textbook] Post-Closing Trial Balance

An additional step in the accounting cycle, prepared after closing, to check that debits equal credits and that all temporary accounts have been closed (have zero balances)

[Textbook] Balance sheet examples – accrued revenues and deferred expenses

Accrued revenues (current assets): accounts receivable, interest receivable, rent receivable. Deferred expenses (current assets): supplies and prepaid expenses (insurance, rent, advertising). Deferred expenses (noncurrent assets): buildings, equipment, operating lease assets, intangible assets.

[Textbook] Balance sheet examples – accrued expenses and deferred revenues

Accrued expenses (current liabilities): interest payable, wages payable, utilities payable, income tax payable. Deferred revenues (current liabilities): unearned revenue.

[Textbook] Effect of adjusting entries on the income statement

Revenues and expenses are INCREASED by adjusting entries. Income tax expense is then subtracted from pretax income to get net income.

[Textbook] Total Asset Turnover Ratio – formula

Total Asset Turnover = Net Sales (or Operating Revenues) ÷ Average Total Assets

[Textbook] Total Asset Turnover Ratio – interpretation

Measures sales generated per dollar of assets. A high or rising ratio means the company is managing its assets more efficiently.

[Textbook] Tip: how to answer "effects" questions (e.g., a missed adjusting entry)

1) Write out what the correct entry should have been. 2) Put in the effects of NOT doing it (O = overstated, U = understated), or the effects of doing it (+/−). 3) Work out the rest of the equation effects starting with the income statement. Whatever the effect is on net income is also the effect on stockholders' equity.

[New MCQ 1] Adjusting journal entries NEVER affect which account?

a) Revenue

b) Cash

c) Liabilities

d) Expenses

b) Cash

[New MCQ 2] A customer pays in advance for a service to be provided next month. At year end, part of the service has been provided. What type of adjustment is needed?

a) Accrued revenue

b) Deferred revenue

c) Deferred expense

d) Accrued expense

b) Deferred revenue. Cash was received first, so part of Unearned Revenue is moved to Revenue.

[New MCQ 3] Unearned revenue is classified as a(n):

a) Asset

b) Liability

c) Revenue

d) Expense

b) Liability. The company owes a good or service to the customer.

[New MCQ 4] Accumulated Depreciation is a(n):

a) Expense

b) Liability

c) Contra-asset

d) Stockholders' equity account

c) Contra-asset. It reduces Plant & Equipment and increases with a credit.

[New MCQ 5] Equipment costs $10,000, has a 5-year useful life, and no salvage value. What is the annual depreciation expense?

a) $1,000

b) $2,000

c) $5,000

d) $10,000

b) $2,000 ($10,000 ÷ 5 years)

[New MCQ 6] Which of the following is a PERMANENT account?

a) Sales Revenue

b) Rent Expense

c) Retained Earnings

d) Interest Revenue

c) Retained Earnings. It is a balance sheet account.

[New MCQ 7] In the closing entry for a company with a NET LOSS, Retained Earnings is:

a) Credited

b) Debited

c) Not affected

d) Closed to zero

b) Debited, for the amount of the net loss

[New MCQ 8] In what order are the financial statements prepared?

a) Balance Sheet, Income Statement, Statement of SE

b) Income Statement, Statement of SE, Balance Sheet

c) Statement of SE, Income Statement, Balance Sheet

d) Income Statement, Balance Sheet, Statement of SE

b) Income Statement, then Statement of SE, then Balance Sheet

[New MCQ 9] Net sales are $500,000 and average total assets are $250,000. What is the total asset turnover ratio?

a) 0.5

b) 2.0

c) 1.5

d) $250,000

b) 2.0 ($500,000 ÷ $250,000)

[New MCQ 10] A company provides services in December but will not bill or collect from the customer until January. The Dec 31 adjusting entry is:

a) Dr Cash / Cr Service Revenue

b) Dr Accounts Receivable / Cr Service Revenue

c) Dr Unearned Revenue / Cr Service Revenue

d) No entry until cash is received

b) Dr Accounts Receivable / Cr Service Revenue (accrued revenue)

[Textbook MCQ 1] Which of the following accounts would NOT appear in a closing entry?

a) Salary Expense

b) Interest Income

c) Accumulated Depreciation

d) Retained Earnings

c) Accumulated Depreciation. It is a permanent balance sheet (contra-asset) account.

[Textbook MCQ 2] Which account is LEAST likely to appear in an adjusting journal entry?

a) Cash

b) Interest Receivable

c) Property Tax Expense

d) Salaries Payable

a) Cash. Adjusting entries never involve cash.

[Textbook MCQ 3] On Oct 1, 20X1, a $12,000 one-year insurance premium was paid and recorded as Prepaid Insurance. Adjusting entry on Dec 31, 20X1?

a) Dr Insurance Exp 2,000 / Cr Prepaid Insurance 2,000

b) Dr Insurance Exp 3,000 / Cr Prepaid Insurance 3,000

c) Dr Prepaid Insurance 3,000 / Cr Insurance Exp 3,000

d) Dr Prepaid Insurance 9,000 / Cr Insurance Exp 9,000

b) Dr Insurance Expense 3,000 / Cr Prepaid Insurance 3,000 (3 months used: $12,000 × 3/12)

[Textbook MCQ 4] On June 1, 20X1, Oakcrest signed a 3-year $110,000 note payable at 9% interest, due each June 1 starting 20X2. Interest expense for the year ended Dec 31, 20X1?

a) $5,250

b) $9,900

c) $4,950

d) $5,775

d) $5,775 ($110,000 × 9% × 7/12, for June through December)

[Textbook MCQ 5] Failing to make an adjusting entry for accrued salaries payable would cause:

a) Understatement of expenses, liabilities, and SE

b) Understatement of expenses and liabilities and overstatement of SE

c) Overstatement of assets and SE

d) Overstatement of assets and liabilities

b) Expenses and liabilities are understated. Net income is too high, so SE is overstated.

[Textbook MCQ 6] An adjusted trial balance:

a) Shows ending balances in debit/credit format before posting adjusting entries

b) Is prepared after closing entries have been posted

c) Shows the ending balances resulting from the adjusting entries in debit/credit format

d) Is a tool used by financial analysts to review public companies

c) Shows the ending account balances resulting from the adjusting entries in debit/credit format

[Textbook MCQ 7] JJ Company owns a building. Which statement about depreciation is FALSE?

a) As depreciation is recorded, SE is reduced

b) Depreciation is an estimated expense recorded over the building's estimated useful life

c) As depreciation is recorded, net book value is reduced

d) As the value of the building decreases over time, it "depreciates"

d) This is false. Depreciation is the allocation of cost over the period of use, not a measure of decline in market value.

[Textbook MCQ 8] Donna Co. had $1,000 of supplies at the start of the year, bought $6,400 more (debited to Supplies), and counted $2,000 at year end. The adjusting entry includes a:

a) Debit to Supplies for $2,000

b) Credit to Supplies Expense for $5,400

c) Credit to Supplies for $5,400

d) Debit to Supplies Expense for $4,400

c) Credit to Supplies for $5,400. Supplies used = 1,000 + 6,400 − 2,000 = 5,400. Entry: Dr Supplies Expense 5,400 / Cr Supplies 5,400

[Textbook MCQ 9] According to GAAP, which ratio must be reported on the financial statements or in the notes?

a) Earnings per share

b) Return on equity

c) Net profit margin

d) Current ratio

a) Earnings per share

[Textbook MCQ 10] If a company acquires several large buildings at the end of the year, what is the effect on the total asset turnover ratio?

a) Increase

b) No change

c) Decrease

d) Either (a) or (c)

c) Decrease. Average total assets go up but sales do not change yet.