Adjustments & Quality of Earnings

• Prepayments occur when goods have been paid for in advance.
• As a buyer, transactions in the past that have not yet been used up are prepaid expenses.
• As a seller, transactions in the past that have not yet been delivered are unearned revenue.
• Accruals happen when goods are to be invoiced in the future.
• As a buyer, future transactions that have not yet been paid for are accrued expenses.
• As a seller, future transactions that have not yet been paid for are accrued revenue.
• Contra Accounts are accounts directly linked to another account but with an opposite balance. They are designated with an “X” in front of the type of account they relate to.
• Net Book Value is the acquisition cost of an asset less its accumulated depreciation, depletion or amortization. It is the amount reported on the balance sheet.
• A Prepaid Expense is a future expense paid in advance.
• Prepaid Expense Adjustment:

  1. In the initial journal entry, cash is credited, and the relevant expense account is debited. However, the expense is overstated, as the benefit from the expense has not yet been received.
  2. An adjusting entry is made where the expense account is credited, and a prepaid expense is debited.
  3. Another adjustment entry is made when the benefit is incurred - the relevant expense account is debited, and the prepaid expense is credited.
• Unearned Revenue is payments received in advance for goods that haven't yet been delivered, which creates a liability.
• Unearned Revenue Adjustment:

  1. In the initial journal entry, cash is debited, and the unearned revenue account is credited.
  2. In the adjusting entry, unearned revenue is debited, and the relevant revenue account is credited.
• Accrued Expense is a past expense not yet recorded with the benefit already delivered.
• Accrued Expense Adjustment:

  1. When the benefit is received, the relevant expense account is debited (with the estimated payment sum), and an accrued expense is credited.
  2. In the adjusting entry, the relevant expense account is debited, and accounts payable are credited.
  3. Consequently, the accrued expense account is debited, and the relevant expense account is credited.
• Accrued Revenue is revenue earned but not yet received.
• Accrued Revenue Adjustment:

  1. When goods are delivered, the relevant revenue account is credited and accrued revenue is debited.
  2. In the adjusting entry, a sales invoice is made by debiting accounts receivable, and accrued revenue is credited.
• Total Asset Turnover Ratio = Operating Revenue / Average Total Assets
• Average Total Assets = (Beginning Balance + Ending Balance) / 2
• The Total Asset Turnover Ratio measures how efficiently a company utilises assets to generate sales. The higher the ratio, the better it is.
• The Total Asset Turnover Ratio can fluctuate due to seasonal changes. As inventory is built up before a heavy sales season, companies must borrow funds. Thus, the ratio declines with this increase in assets. The ratio then rises once the high sales provide the cash to repay the loans and get rid of the inventory.
• Trial Balance is a financial report showing the closing balances of all accounts in the general ledger at a point in time.
• Closing Entries are made at the end of the accounting period to transfer balances in temporary accounts to Retained Earnings and establish a zero balance in each of those accounts.
• In a closing entry, revenues are debited, and expenses are credited. This is done to reset these temporary accounts to zero. Retained Earnings are credited if there is net income and debited if there is a net loss.
• Adjusting entries are journal entries posted at the end of each period to align the books with the accrual basis of accounting.