Introductory Financial Accounting II

Chapter 4 Lecture
Adjustments, Financial Statements, and the Closing Entries
Professor Jonathan Muterera Ph.D., FCPA. CPA, CFE
Learning Objectives
• LO4-1 Explain the purpose of adjusting entries and analyze the
adjustments necessary at the end of the period to update revenues
and 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 the net profit margin ratio and the
return on equity.
• LO4-4 Explain the closing process at the end of the period.
The Accounting Cycle Part 1
• The accounting cycle is the process used by entities to analyze and record
transactions, adjust the records to provide reliable account balances at the end of
the period, prepare financial statements, and prepare the records for the next
cycle.
• During the accounting period, transactions that result in exchanges of benefits
and obligations between the company and other external parties are analyzed
and recorded in the general journal in chronological order (journal entries), and
the related accounts are updated in the general ledger (T-accounts).
• The end-of-period steps focus primarily on adjustments to record revenues and
expenses in the proper period and to update the statement of financial position
accounts for reporting purposes.
The Accounting Cycle Part 2
Four Types of Adjustments
Purpose of Adjustments Part 1
• Adjusting entries are recorded at the end of every accounting
period, so that
• Revenues are recorded when earned (the revenue recognition principle).
• Expenses are recorded when incurred to generate revenue during the same
period (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.
Purpose of Adjustments Part 2
• Companies wait until the end of the accounting period to adjust their
accounts, because adjusting the records daily would be very costly
and time-consuming.

• Adjusting entries are required every time a company wants to

prepare financial statements for external users.
Adjustment Process Part 1
 Step 1: Ask: Was revenue earned that is not yet recorded?
If the answer is YES, increase the revenue account —credit the revenue account in the adjusting entry.
 Step 2: Ask: Was the related cash received in the past or will it be received in the future?
 If cash was received in the past, a deferred revenue (liability) account was recorded in the past ⟶ now,
reduce (debit) the liability account (usually deferred revenue) that was recorded when cash was received,
because the company has fulfilled its obligations to the customer and decreased all or part of its liability.
 If cash will be received in the future ⟶ increase (debit) the receivable account (such as interest receivable
or rent receivable) to record what is owed by others to the company (creates accrued revenue).
 Step 3: Compute the amount of revenue earned and record the adjusting entry.
 Sometimes the amount is given or known. At other times it must be computed, or sometimes estimated.
Adjustment Process Part 2
 Step 1: Ask: Was an expense incurred that is not yet recorded?
 If the answer is YES, increase the expense account—debit the expense account in the adjusting entry.
 Step 2: Ask: Was the related cash paid in the past or will it be paid in the future?
 If cash was paid in the past, a deferred expense account (asset) was recorded in the past ⟶ now, reduce
(credit) the asset account (such as supplies or prepaid expenses) that was recorded in the past because the
entire asset or part of it has been used since then. (A variation of this concept will be illustrated for the use
of buildings, equipment, and some intangible assets.)
 If cash will be paid in the future ⟶ increase (credit) the payable account (such as interest payable or
wages payable) to record what is owed by the company to others (creates an accrued expense).
 Step 3: Compute the amount of expense incurred and record the adjusting entry.
 Sometimes the amount is given or known. At other times it must be computed, or sometimes estimated.
Adjusting Entries Summary
When revenue is earned When expense is incurred

DEFERRED REVENUE DEFERRED EXPENSE

If cash was received and previously If cash was paid and previously recorded
recorded

Cash (+A) xx Prepaid expense (+A) xx

Deferred revenue (+L) xx Cash (–A) xx

the adjusting entry is the adjusting entry is

Deferred revenue (–L) xx Expense (+E, –SE) xx

Revenue (+R, +SE) xx Prepaid expense (–A) xx

OR OR
ACCRUED REVENUE ACCRUED EXPENSE

If cash will be received, the If cash will be paid, the adjusting entry is
adjusting entry is

Accounts receivable (+A) xx Expense (+E, –SE) xx

Revenue (+R, +SE) xx Payable (+L) xx

Deferred Revenues
• When a customer pays for goods or services before the company
delivers them, the company records the amount of cash received in a
deferred revenue account.
• Deferred revenue is a liability representing the company’s promise
to perform or deliver the goods or services in the future.
• Recognition of (recording) the revenue is deferred (postponed) until
the company meets its obligation.
• Examples include rent received in advance, magazine subscriptions,
season tickets to sporting events, plays, and concerts, and airline
tickets sold in advance.
• Adjusting Entry: Decrease Liability and Increase Revenue
Accrued Revenues
• Sometimes, companies perform services or provide goods (i.e., earn
revenue) before customers pay.
• Because the cash that is owed for these goods has not yet been
received, the revenue that was earned has not been recorded.
• Revenues that have been recognized (earned) but have not yet been
realized in cash and recorded at the end of the accounting period are
called accrued revenues.
• Examples include interest on notes receivable and rent of facilities
that have not been received in cash by the end of the accounting
period.
• Adjusting Entry: Increase Asset and Increase Revenue
Deferred Expenses
• Assets represent resources with probable future benefits to the
company. Many assets are used over time to generate revenues,
including supplies, prepaid rent, prepaid insurance, buildings,
equipment, and intangible assets, such as patents and copyrights.
These assets are deferred expenses.
• At the end of every period, an adjustment must be made to record the
amount of the asset that was used during the period.
• Examples include supplies, prepaid expenses (e.g., rent, insurance)
and buildings and equipment.
• Adjusting Entry: Increase Expense and Decrease Asset
Property, Plant, and Equipment Part 1
• Property, plant, and equipment increases when assets
are acquired and decreases when they are sold or disposed of.

• However, these assets are also used over time to generate revenue.
Thus, a part of their cost should be expensed in the same period
(following the expense recognition principle).

• These assets depreciate over time as they are used. In

accounting, depreciation is an allocation of an asset’s cost over its
estimated useful life to the organization.
Property, Plant, and Equipment Part 2
• 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.
• A contra account is an account that is an offset to, or reduction of,
the primary account. It is directly related to another account, but has
a balance on the opposite side of the T-account.
• As a contra account increases, the net amount (the account balance
less the contra-account balance) decreases. For property, plant, and
equipment, the contra account is called accumulated depreciation.
Property, Plant, and Equipment Part 3
• Since assets have debit balances, accumulated depreciation has a
credit balance.

• On the statement of financial position, the amount that is reported for

property, plant, and equipment is its carrying amount (book value
or net book value), which equals the ending balance in the property,
plant, and equipment account minus the ending balance in the
accumulated depreciation account.
Accrued Expenses
• Numerous expenses are incurred in the current period without being
paid for until the next period.
• Common examples include interest expense incurred on debt, wages
expense for the wages owed to employees, and utilities expense for
water, gas, and electricity used during the period for which the
company has not yet received a bill.
• These accrued expenses accumulate (accrue) over time but are not
recognized until the end of the period in an adjusting entry.
• Examples include interest payable, wages payable, and property taxes
payable.
• Adjusting Entry: Increase Expense and Increase Liability
Preparing Financial Statements
• Financial statements are interrelated; that is, the numbers from one
statement flow into the next statement.
• The adjusted balances in the trial balance is what is used to prepare
the statement of earnings, the statement of changes in equity (which
includes a column for retained earnings), and then the statement of
financial position.
• Exhibit 4.4 highlights the interconnections among the statements
using the fundamental accounting equation, followed by a summary
structure of each statement highlighting relationships. This is shown
on the next slide.
Interrelationships of Financial Statements
Statement of Earnings
• The statement of earnings is prepared first, because net earnings is a
component of retained earnings, which is reported on the statement
of changes in equity.

• The earnings per share (EPS) ratio is reported on the statement of

earnings. It is widely used in evaluating the operating performance
and profitability of a company and is the only ratio required to be
disclosed on the statement or in the notes to the financial statements.
Earnings Per Share (EPS)
• The actual calculation for EPS is quite complex and appropriate for
intermediate accounting courses; however, in this text we simplify
the earnings per share calculation to be:
Net earnings
Earnings per share = Average number of common shares
Outstanding during the period
Statement of Changes in Equity
• The final amount from the statement of earnings, net earnings,
is carried forward to the retained earnings column of the statement
of changes in equity.

• Net earnings is an increase in Retained Earnings.

• Dividends declared during the period are deducted to arrive at the

ending balance. The issuance of additional shares is added to the
beginning balance of contributed capital.
Statement of Financial Position
• The ending balances under the headings contributed capital, retained
earnings, and other components on the statement of changes in
equity are included on the statement of financial position.

• Assets are listed in order of liquidity, while liabilities are listed in

order of time to maturity.

• Current assets are those used or turned into cash within one year.
Current liabilities are obligations to be settled within one year.
Net Profit Margin Ratio
 The net profit margin ratio compares net earnings to the revenues
generated during the period.

ANALYTICAL QUESTION → How effective is management at

controlling revenues and expenses to generate more earnings?
RATIO AND COMPARISONS → The net profit margin ratio is useful
in answering this question. It is computed as follows:

Net Profit Net Earnings

=
Margin Ratio Net Sales (or Operating revenues)*
*Net sales is sales revenue less any returns from customers, and other reductions. For companies in the service
industry, total operating revenues equals net sales.
Net Profit Margin Ratio Interpretations
• The net profit ratio margin measures how much profit is earned as a
percentage of revenues generated during the period.

• A rising net profit margin ratio signals more efficient management of

sales and expenses.

• Financial analysts expect well-run businesses to maintain or improve

their net profit margin ratio over time.
Return on Equity (ROE)
 The return on equity relates net earnings to shareholders’ investment
in the business.
ANALYTICAL QUESTION → How well has management used
shareholder investment to generate net earnings during the period?
RATIO AND COMPARISONS → The return on equity (ROE) helps
in answering this question. It is computed as follows:
​
Return on Net Earnings
=
Equity Average Shareholders’ Equity*
*Average shareholders’ equity = (Beginning shareholders’ equity + Ending shareholders’ equity) ÷ 2
Return on Equity Interpretations
• ROE measures how much the firm earned, on average, for every
dollar invested by shareholders.

• In the long run, firms with higher ROE are expected to have higher
share prices than firms with lower ROE, all other things being equal.

• Managers, analysts, and creditors use this ratio to assess the

effectiveness of the company’s overall business strategy (its
operating, investing, and financing strategies).
Closing the Books
• All adjusting entries are recorded and posted to update the accounts
and then 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.
End of the Accounting Cycle
• Statement of financial position accounts are permanent (real)
accounts and are not reduced to zero at the end of the accounting
period. The ending balance for the current accounting period
becomes the beginning account balance for the next accounting
period.
• However, revenue, expense, gain, loss, and dividend accounts are
used to accumulate transaction effects for the current accounting
period only; they are called temporary (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 closing entries.
Closing Entries
 The closing entries have two purposes:

1. To transfer the balances in the temporary accounts to retained

earnings.
2. To establish a zero balance in each of the temporary accounts to start
the accumulation in the next accounting period.
Steps for Closing Entries Part 1
• The closing process requires three journal entries:
• one entry to close the revenue and gain accounts,
• another entry to close the expense and loss accounts, and
• a final entry to close the dividends declared account.

• Income Summary, is a temporary account used only during the

closing process to facilitate closing temporary accounts.
Steps for Closing Entries Part 2
• Revenue and gain accounts, which have credit balances, are closed
by debiting each account for the account balance and crediting the
total amount to income summary.

• Expense and loss accounts, which have debit balances, are closed by
crediting each account for the account balance and debiting the total
amount to income summary.
Steps for Closing Entries Part 3
• The balance of the income summary account reflects the net earnings
(loss) and is then closed to the retained earnings account.

• The statement of earnings accounts are again ready for their

temporary accumulation function for the next period.

• Closing entries are dated the last day of the accounting period,
entered in the usual format in the journal, and immediately posted to
the ledger (or T-accounts).
Post-Closing Trial Balance
• After the closing process is complete, all of the statement of earnings
accounts have a zero balance. These accounts are ready for recording
the effects of transactions that generate revenues and incur expenses
in the new accounting period.

• The ending balance in retained earnings is now up to date and is

carried forward as the beginning balance for the next period.

• A post-closing trial balance should be prepared as the last step of the

accounting cycle to check that debits equal credits and that all
temporary accounts have been closed.
End of Chapter Summary Part 1
• Adjusting entries are necessary at the end of the accounting period to
measure earnings properly, correct errors, and provide for adequate
valuation of financial statement accounts.

• There are four types of adjustments:

1. Deferred revenues
2. Accrued revenues
3. Deferred expenses
4. Accrued expenses
End of Chapter Summary Part 2
• A rising net profit margin ratio signals more efficient management of
revenues and expenses.

• Managers, analysts, and creditors use the ROE ratio to assess the
effectiveness of the company’s overall business strategy.

• Temporary accounts (revenues, expenses, gains, and losses) are

closed to a zero balance at the end of the accounting period to allow
for the accumulation of these items in the following period and to
update retained earnings for the period’s net earnings.