AFA100_45_Winter2024_Chapter4

Chapter 4: Adjustments, Financial Statements, and the Closing Process

Introduction

• Course: AFA100, Introductory Financial Accounting

• Institution: Toronto Metropolitan University

Last Week Overview

• Topics covered in Week 2:

  • Business Transactions and Accounting Cycle

  • Debit and Credit

  • Journal Entries and T-Accounts

  • Accrual Accounting vs Cash Accounting

  • Revisit Statement of Earnings

Chapter 4 Learning Objectives

• LO4-1: Explain the purpose of adjusting entries; analyze necessary adjustments at period-end to update revenues, expenses, and related statement of financial position accounts.

• LO4-2: Prepare a statement of earnings with earnings per share, a statement of changes in equity, and a statement of financial position.

• LO4-3: Compute and interpret net profit margin ratio and return on equity.

• LO4-4: Explain the closing process at the end of the accounting period.

Accounting Cycle Overview

1. Analyze Transactions

2. Journalize

3. Post

4. Adjusting Entries

5. Prepare Financial Statements

6. Closing Entries

Actions During the Accounting Period

• Analyze transactions using source documents.

• Record journal entries in the general journal.

• Post entries to the general ledger.

• Close revenues, expenses, gains, and losses to retained earnings.

• Prepare a post-closing trial balance.

Actions at the End of the Period

• Prepare a trial balance.

• Analyze account balances.

• Record and post adjustments to revenue, expense, and related accounts.

• Prepare an adjusted trial balance.

• Prepare a complete set of financial statements.

• Disseminate statements to users.

Adjusting Entries

• Adjustments are made at the end of the accounting period to correctly reflect revenues and expenses in financial statements.

• Adjusting entries consist of two components:

  1. Cash Entries: record cash received or paid.

  2. Revenue/Expense Recognition: adjust entries to reflect revenues or expenses in the correct accounting period.

Types of Adjusting Entries

• Deferrals: Payment received or made before recognizing revenue or expense.

• Accruals: Revenue earned or expense incurred but not yet recorded.

Detailed Explanation of Adjusting Entries

• Deferred Revenue:

  • Liability recorded when cash is received before delivering goods/services.

  • Example: Rent received in advance.

  • Adjusting Entry: Decrease Liability (Deferred Revenue) and Increase Revenue.

• Accrued Revenue:

  • Revenue earned before cash is received.

  • Example: Interest receivable.

  • Adjusting Entry: Increase Asset and Increase Revenue.

• Deferred Expenses:

  • Expenses paid in cash before they are incurred (assets).

  • Example: Prepaid insurance.

  • Adjusting Entry: Decrease Asset (Prepaid Expense) and Increase Expense.

• Accrued Expenses:

  • Expenses incurred but not paid.

  • Example: Wages payable.

  • Adjusting Entry: Increase Expense and Increase Liability.

Adjusting Process Steps

1. Determine if Revenue is Earned:

   • If yes, increase the revenue account.

   • Check if cash was received earlier (Deferred Revenue) or will be received later (Accrued Revenue).

2. Determine if Expense is Incurred:

   • If yes, increase the expense account.

   • Check if cash was paid earlier (Deferred Expense) or will be paid later (Accrued Expense).

3. Compute Amount:

   • Record the adjusting entry based on computations or estimates.

Deferred and Accrued Revenue/Expense Charts

Deferred Revenue

• Cash received before revenue earned.

• Adjusting Entry:

  • Cash (+A)

  • Deferred Revenue (+L)

  • Revenue (+R)

Accrued Revenue

• Revenue earned but cash not received.

• Adjusting Entry:

  • Revenue (+R)

  • Receivable (+A)

Deferred Expense

• Cash paid before expense incurred.

• Adjusting Entry:

  • Expense (+E)

  • Prepaid expense (-A)

Accrued Expense

• Expense incurred but cash not yet paid.

• Adjusting Entry:

  • Expense (+E)

  • Payable (+L)

Depreciation Expenses

• Concept: Property, plant, and equipment decrease in value as they are used for revenue generation.

• Mechanism: Allocate the asset’s cost over its estimated useful life.

• Contra Account: Accumulated depreciation (offset to primary asset account).

• Reporting: Carrying amount = Asset value - Accumulated depreciation.

Materiality in Adjusting Entries

• Materiality: Significance of information affecting economic decision-making.

• Treat minor items economically under accounting standards; low-cost assets may bypass depreciation rules.

Trial Balances

• Unadjusted Trial Balance: Lists account balances before adjustments. Debits must equal credits. Errors surface if totals do not match.

• Adjusted Trial Balance: Post all adjusting entries; used for financial statements.

• Post-Closing Trial Balance: Shows balances for permanent accounts only (assets, liabilities, equity) after closing entries.

Financial Statements Preparation

• Statement of Earnings: Report net earnings; EPS calculated for performance evaluation.

• Statement of Changes in Equity: Reflects net earnings and dividends affecting retained earnings.

• Statement of Financial Position: Lists assets and liabilities, assets ordered by liquidity.

Key Ratios

Net Profit Margin Ratio

• Definition: Relates net earnings to revenues.

• Significance: Measures management's efficiency in controlling costs.

Return on Equity (ROE)

• Definition: Compares net earnings to shareholder investments.

• Implication: Firms with higher ROE expected to have better share prices.

Closing The Books

• Types of Accounts:

  • Permanent Accounts: Assets, liabilities, equity (carry balances).

  • Temporary Accounts: Revenues, expenses, gains, losses (zeroed out at period-end).

• Process:

  1. Close revenue accounts to Income Summary.

  2. Close expense accounts to Income Summary.

  3. Transfer Income Summary to Retained Earnings.

  4. Close Dividends declared to Retained Earnings.

End of Chapter Summary

• Reviewed concepts related to adjusting entries:

  • Deferred and accrued revenues/expenses.

  • Depreciation expenses.

  • Signing off on adjusted trial balances and the closing of books.

Next Week's Topic

• Chapter 5: Reporting and Interpreting Sales Revenue, Receivables, and Cash (Part 1 - Accounts Receivable)