Adjustments, Financial Statements, & the Quality of Earnings

Creation of Financial Statements:

• During the Accounting Period:

  • Analyze business transactions

  • Record transactions using journal entries

  • Aggregate journal entries

• End of the Accounting Period:

  • Prepare the (unadjusted) trial balance

  • Make adjusting entries (record & post)

  • Prepare financial statements

  • Close temporary accounts

“Regular” Journal Entry:

• Recorded in the normal course of daily business transactions

• May or may not involve cash (ie selling goods to customers for cash, buying inventory on account)

• May or may not involve recording Revenue or Expenses

Adjusted Journal Entry (AJEs):

• Recorded at the end of the accounting period

• Never involves cash

• Always involves Revenue or Expenses

• Necessary because:

  • Timing differences between Revenues being earned vs receipt of cash

  • Timing differences between Expenses being incurred vs exchange of cash

  • Expenses that are difficult or inefficient to recognize on a daily basis (ie depreciation expense)

Types of Adjusting Entries:

• Deferred Revenue:

  • Revenue after cash

  • Inception: A liability (ie promise from future services) was recorded at the time cash was received

  • Adjustment: Liability is reduced to recognize revenue earned

  • Conclusion: Liability is eliminated & remaining revenue is recognized

Accrued Revenue:

• Revenue before cash

• Inception: Reaches an agreement for future services; no transaction in most cases

• Adjustment: Revenue earned for services performed; receivable is increased

• Conclusion: Cash receipt recorded, receivable eliminated, & remaining revenue recognized (if any)

Deferred Expense:

• Expenses after cash

• Inception: An asset was acquired at the time cash was paid

• Adjustment: Asset is used; asset balance reduced to recognize expense incurred

• Conclusion: Asset is eliminated & remaining expense is recognized

Accrued Expense:

• Expenses before cash

• Inception: Reaches an agreement for future services; no transaction

• Adjustment: Expense incurred for services received; payable is increased

• Conclusion: Cash payment made, payable eliminated, remaining expense recognized (if any)

Closing the Books:

• The balance sheet provides a snapshot of a company’s resources & sources at a given date

  • These balances carry forward from period to period

  • Balance sheet accounts are permanent accounts

• The income statement provides a report of performance over a period

  • These account balances need to be reset at zero each period so current period income is not included in future income

  • Income statement accounts are temporary accounts

Total Asset Turnover Ratio: