Chapter 4 Adjustments, Financial Statements, And Financial Results

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Adjustments

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These adjustments are made to accounting records at the end of the period to ensure assets and liabilities are reported at appropriate amounts. These adjustments ensure the related revenues and expenses are reported in the proper period as required by the revenue and expense recognition principles.

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Revenues

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Are recorded when earned (the revenue recognition principle).

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Expenses

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Are recorded in the same period as the revenues to which they relate (the expense recognition or matching principle).

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Assets

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Are reported at amounts representing economic benefits that remain at the end of the current period.

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Liabilities

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Are reported at amounts owed at the end of the current period that will require a future sacrifice of resources.

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When Are Adjustments Made & Why?

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Companies wait until the end of the accounting period to adjust their accounts because daily adjustments would be costly and time consuming. Almost every financial statement account could require adjustment.

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Deferral Adjustments

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This means that an expense or revenue has been deferred in posting/reporting on the income statement until a later period.

1. Deferral adjustments are used to decrease balance sheet accounts and increase corresponding income statement.

2. Each deferral adjustment involves one asset and one expense account, or one liability and one revenue account.

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Accrual Adjustments

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Accrual Adjustments are needed when a company has earned revenue or incurred an expense in the current period but has not yet recorded it because the related cash will not be received or paid until a later period.

1. Accrual adjustments are used to record revenue or expenses when they occur prior to receiving or paying cash, and to adjust corresponding balance sheet accounts.

2. Each accrual adjustment involves one asset and one revenue account, or one liability and one expense account. This differs from deferral adjustments, which pair assets with expenses and liabilities and revenues.

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Depreciation

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The expense recognition principle indicates that when equipment is used to generate revenues in the current period, part of its cost should be transferred to an expense account in that period. An income statement account named Depreciation Expense reports the cost of equipment use in the current period. On the balance sheet, we reduce the amount reported for equipment but we don't take, the amount of depreciation directly out of the Equipment account.

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Contra-Account

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Is created to keep track of all the depreciation recorded against the equipment. This contra-account, named Accumulated Depreciation, is like a negative asset account that is subtracted from the Equipment account in the assets section of the balance sheet.

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Accumulated Depreciation

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1. Accumulated Depreciation is a balance sheet account and Depreciation Expense is an income statement account.

2. By recording depreciation in Accumulated Depreciation, separate from the Equipment account, you can report both the original cost of equipment and a running total of the amount that has been depreciated.

3. The normal balance in a contra-account is always the opposite of the account it offsets.

4. The amount of depreciation depends on the method used for determining it.

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Dividends

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The decision to pay a dividend is made by the company's board of directors after profits have been generated, so dividends are not expenses of the business. Instead, they are a reduction of the retained earnings. Consequently, dividends are not reported on the income statement, but instead are subtracted on the Statement of Retained Earnings. They are declared in their own special account called Dividends Declared. Because dividends reduce stockholders' equity, they are recorded with a debit just like all reductions in stockholders' equity.

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Adjusted Trial Balance

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Is prepared to check that the accounting records are still in balance, after having posted all adjusting entries to the T-Accounts. To prepare an adjusted trial balance, just copy the adjusted T-Account balances into the debit or credit columns of the adjusted trial balance.

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Closing Temporary Accounts

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The last step of the accounting cycle is referred to as the closing process. This step is only performed at the end of the year, after the financial statements have been prepared. The closing process cleans up the accounting records to get them ready to begin tracking the results in the following year.

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Closing Income Statement and Dividend Accounts

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At the end of each year, after all the year's transactions and adjustments are recorded, all revenue, expense, and dividends declared accounts are closed by moving their balances to their permanent home in Retained Earnings.

The Retained Earnings account, like all other balance sheet accounts, is considered a permanent account because its ending balance from year becomes its beginning balance for the following year.

In contrast, revenues, expenses, and dividends declared are considered temporary accoutns because they are used to track only the current year's results and then are closed before the next year's activities are recorded.

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Purpose of the Closing Process

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1. Transfer net income (or loss) and dividends to Retained Earnings. After the closing journal entries are prepared and posted, the balance in the Retained Earnings account will agree with the ending Retained Earnings balance on the statement of retained earnings and the balance sheet.

2. Establish zero balances in all income statement and dividend accounts. After the closing journal entries are prepared and posted, the balances in the temporary accounts are reset to zero to start accumulating next year's results.

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Closing Journal Entries

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1. Debit each revenue account for the amount of its credit balance, credit each expense account for the amount of its debit balance, the amount credited to Retained Earnings should equal Net Income on the Income Statement. (If the company has a net loss, the Retained Earnings will be debited)

2. Credit the Dividends Declared account for the amount of its debit balance and debit Retained Earnings for the same amount.

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Post-Closing Trial Balance

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After the closing journal entries are posted, all temporary accounts should have zero balances. These accounts will be ready for summarizing transactions recorded next year. The ending balance in Retained Earnings is now up to date (it matches the year-end amount on the statement of retained earnings and the balance sheet) and carried forward as the beginning Retained Earnings balance for the next year.

As the last step of the accounting cycle, you should prepare a post closing trial balance. In this context, post means "after", so a post-closing trial balance is an "after-closing" trial balance that is prepared as a final check that total debits still equal total credits and that all temporary accounts have been closed.

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Post-Closing Trial Balance Accumulated Depreciation

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Total debits on the post-closing trial balance don't equal the total assets on the balance sheet because Accumulated Depreciation (is subtracted from assets on the Balance Sheet).