Chapter 4: Adjustments, Financial Statements, and Financial Results

Objective 4.1: Explain why adjustments are needed.

Why Adjustments Are Needed

• Accounting systems records daily transactions. Sometimes cash does not come in or paid immediately.
• Cash may not be paid or received in period related to revenues or expenses.
• For adjusting journal entries, there is ^^no cash involved^^.
• Adjustments are made ^^at the end^^ of the accounting period.
• Adjusting entries always have one balance sheet account and one income statement account.
• The purpose of adjustments at the end of the period is to state the following at appropriate amounts:
    * Assets are reported at amounts representing the economic benefits that remain at the end of the accounting period.
    * Liabilities are reported as amounts owed at the end of the accounting period.
    * Revenues are recorded after service or sale is provided (revenue recognition principle).
    * Expenses are recorded in the same period that we needed the expense to earn revenue (expense recognition/”matching” principle).
• ^^There are two categories for adjustments^^:
    * Deferrals
    * Accruals

Deferral Adjustments

• Defer means to postpone until later.
• Deferral adjustments arise because a cash transaction happened first.
• ^^There are two things to considered regarding deferral adjustments^^:
    * Deferral adjustments are used to DECREASE balance sheet accounts and INCREASE corresponding income statement accounts.
    * Each deferral adjustment involves:
      * One asset and one expenses account OR
      * One liability and one revenue account.
• Regarding expenses:
    * Assets such as supplies or prepaid rent are reported on the balance sheet.
    * Once these assets are used, they move over to the income statement as “supplies expense” or “rent expense”.
• Regarding revenues:
    * A liability, specifically “deferred revenue”, is reported on the balance sheet.
    * Once a service or sale is provided, the deferred revenue is moved onto the income statement as “sales revenue” or “service revenue”.

Accrual Adjustments

• Accrual adjustments are needed when a company has earned revenue or incurred an expense in the current period but has not recorded it because cash will be paid later.
• ^^There are two things to consider regarding accrual adjustments^^:
    * These adjustments are used to record revenues or expenses when they occur prior to receiving or paying cash, and to adjust corresponding balance sheet accounts.
    * Each accrual adjustment involves:
      * One asset and one revenue account OR
      * One liability and one expense account.
• ^^Cash is never in an accrual adjustment^^ because cash is paid or received AFTER.
• Regarding revenues:
    * Assets on the balance sheet will be followed by the word “receivable” (ex: rent receivable, interest receivable), meaning the right to collect later.
    * Once collected, the asset moves to the income statement as rent or interest revenue.
• Regarding expenses:
    * Liabilities are reported on the balance sheet and will be followed by the word “payable” (wages payable, interest payable), meaning they will have to pay later.
    * Once the liability is paid, it moves to the income statement as an expense (wages expense, interest expense).

Deferral vs Accrual Accounting

• For deferral adjustments, assets are paired with expenses and liabilities are paired with revenues.
• For accrual adjustments, assets are paired with revenues and liabilities are paired with expenses.

Objective 4.2: Prepare adjustments needed at the end of the period.

Adjustment Analysis, Recording, and Summarizing

• ^^Adjustments are not made daily^^ because it is more efficient for them to be made at the end of the accounting period.
• The first step is to find the current unadjusted balances.
• Next, the desired adjustments should be identified.
• Make the adjustments and create the adjusted trial balance to ensure debits still equal credits.
• If debits do equal credits and there are no further adjustments, the final financial statement can be made.

Depreciation

• Depreciation is the process of allocating the cost of buildings, vehicles, and equipment (tangible assets) to the accounting periods in which they are used.
• The expense recognition principle says that when equipment is used to generate revenue, part of the cost is becomes an expense.
• With depreciation, an account on the income statement called Depreciation Expense records the cost of equipment at the time.
• On the balance sheet, we use the contra account Accumulated Depreciation to record the reduced value of the equipment.
• ^^The journal entry^^:
    * Debit Depreciation Expense
    * Credit Accumulated Depreciation
• A contra account is an account that is an offset to, or reduction of, another account.
    * It can never be alone, it must be attached to another account.
    * Its purpose is to bring down the value of the account its “stuck” to.
    * The contra account’s normal balance is the opposite of the account its stuck to.

Amortization

• Amortization is the corollary to depreciation and relates to intangible assets.
• An amortization expense is an expense on the income statement.
• Accumulated amortization:
    * Found on the balance sheet.
    * Attaches itself to advertisements, patents, software etc.
    * It brings the value down for the assets.
    * It has a normal credit balance.

Objective 4.3: Prepare an adjusted trial balance.

Adjusted Trial Balance

• The adjusted trial balance ensures that debits still equal credits.
• Adjusted t-accounts balances are transferred into debit and credit columns.
• Accumulated Depreciation and Accumulated Amortization belong with assets.
• The trial balance lists accounts in the order they will appear in the balance sheet, statement of retained earnings, and income statement.

Objective 4.4: Prepare financial statements.

Financial Statements

• Account balances from the adjusted trial balances are in the Statement of Retained Earnings.
• The total of Retained Earnings and Dividends from the adjusted trial balance equal beginning Retained Earnings on the Statement of Retained Earnings.
• Retained Earnings should be from the Statement of Retained Earnings and not the adjusted trial balance.

Objective 4.5: Explain the closing process.

Closing Accounts

• The closing process is done at the end of the year.
• Accounting records are prepped to be tracked in the following year.
• Accounts that are ^^tracked for a limited period of time^^ and closed at the end of the year are called temporary accounts, which consists of revenues, expenses, and dividends.
• Net income or loss and dividends are moved into the Retained Earnings account (subcategory of stockholders’ equity).
• Accounts that are not closed and ^^carry into the next year^^ are called permanent accounts, which consists of assets, liabilities, and stockholders’ equity.
• Retained earnings for the end of the year becomes the beginning balance for the next year.
• ^^2 journal entries for closing accounts are needed^^:
    * Entry 1.) Debit revenue accounts, credit expense accounts, then debit or credit the difference to Retained Earnings.

• Entry 2.) Debit Retained Earnings and credit Dividends

Post Closing Trial Balance

• Post closing entries are the last step in the accounting process and will ensure all income statement accounts and the dividend account have a zero balance.
• The post closing trial balance is the last step to check:
    * If debits are still equal to credits.
    * If all temporary accounts are closed.
• The post closing trial balance will only have the balances of permanent accounts, ^^temporary accounts should be zero^^. It should look like:

Objective 4.6: Explain how adjustments affect financial results.

Adjusted Financial Results

• Adjustments show that revenues (earned) and expenses (incurred) are reported properly.
• If there were no adjustments, a company’s performance would have an inaccurate portrayal.