Chapter 03 - Adjusting Accounts and Preparing Financial Statements
Chapter 3
Adjusting Accounts and Preparing Financial Statements
Questions
1. The cash basis of accounting reports revenues when cash is received while the accrual basis reports revenues when they are earned. The cash basis reports expenses when cash is paid while the accrual basis reports expenses when they are incurred and matched with revenues they generated.
2. The accrual basis of accounting generally provides a better indication of company performance and financial condition than does the cash basis. Also, the accrual basis increases the comparability of financial statements from one period to the next. Thus, business decision makers generally prefer the accrual basis.
3. Businesses that have major seasonal variations in sales are most likely to select the natural business year as the fiscal year.
4. A prepaid expense is an item paid for in advance of receiving its benefits. As such, it is reported as an asset on the balance sheet.
5. Long-term tangible plant assets such as equipment, buildings, and machinery lead to adjustments for depreciation. Generally, land is the only long-term tangible plant asset that does not require depreciation.
6. The Accumulated Depreciation contra asset account is used for depreciation. It provides financial statement users with additional information about the relative age of the assets. Without the contra account information, the reader would not be able to tell whether the assets are new or in need of replacement.
7. Unearned revenue refers to cash received in advance of providing products and services. Another name for unearned revenue is deferred revenue. It is reported as a liability on the balance sheet.
8. Accrued revenue is revenue that is earned but is not yet received in cash (and/or other assets) and the customer has not been billed prior to the end of the period. Therefore, end-of-period adjustments are made to record accrued revenue. Examples are interest income that has been earned but not collected and revenues from services performed that are neither collected nor billed.
9.A If prepaid expenses are initially recorded with debits to expense accounts, then the prepaid expenses asset accounts are debited in the adjusting entries.
10. For Research In Motion, all of the accounts under the category of Property and Equipment (except for Land), require adjusting entries. The expense related to the Depreciation Expense account would be understated on the income statement if Research In Motion fails to adjust these asset accounts. If the adjusting entries are not made, net income would be overstated. Note: Students might also correctly identify accounts receivable (for bad debts), Intangible assets (for amortization), Inventories (for shrinkage), and Short- and Long-term investments (for fair value) as needing adjustment.
11. Nokia reports 1,867 EUR (000,000s) for property, plant and equipment. For its adjusting entry, it would need to record Depreciation Expense (debit) on the plant and equipment and Accumulated Depreciation (credit) as the contra to the Property, plant and equipment account.
12. The accrued wages would be reported as part of the liability “Other Accrued Liabilities” on Palm’s balance sheet.
Quick StudIES
Quick Study 3-1 (10 minutes)
a. UR Unearned revenue
b. PE Prepaid expenses (Depreciation)
c. AE Accrued expenses
d. AR Accrued revenue
e. PE Prepaid expenses
Quick Study 3-2 (10 minutes)
a. Insurance Expense 1,800
Prepaid Insurance 1,800
To record 6-month insurance coverage expired.
b. Supplies Expense 2,700
Supplies 2,700
To record supplies used during the year.
($1,000 + $3,000 – [?] = $1,300)
Quick Study 3-3 (10 minutes)
a. Depreciation Expense—Equipment 5,000
Accumulated Depreciation—Equipment 5,000
To record depreciation expense for the year.
($30,000 - $5,000) / 5 years = $5,000
b. No depreciation adjustments are made for land as it is expected to last indefinitely.
Quick Study 3-4 (15 minutes)
a. Unearned Revenue 15,000
Legal Revenue 15,000
To recognize legal revenue earned (20,000 x 3/4).
b. Unearned Subscription Revenue 2,400
Subscription Revenue 2,400
To recognize subscription revenue earned.
[100 x ($48 / 12 month) x 6 months]
Quick Study 3-5 (10 minutes)
Salaries Expense 400
Salaries Payable 400
To record salaries incurred but not yet paid.
[One student earns, $100 x 4 days, M-R]
Quick Study 3-6 (15 minutes)
Accounts Debited and Credited / Financial Statementa. / Debit / Unearned Revenue / Balance Sheet
Credit / Revenue Earned / Income Statement
b. / Debit / Depreciation Expense / Income Statement
Credit / Accumulated Depreciation / Balance Sheet
c. / Debit / Wages Expense / Income Statement
Credit / Wages Payable / Balance Sheet
d. / Debit / Accounts Receivable / Balance Sheet
Credit / Revenue Earned / Income Statement
e. / Debit / Insurance Expense / Income Statement
Credit / Prepaid Insurance / Balance Sheet
Quick Study 3-7 (10 minutes)
Cash Accounting:
Revenues (cash receipts) $33,000
Expenses (cash payments: $22,500 - $2,250 + $3,750) 24,000
Net income $ 9,000
Accrual Accounting:
Revenues (earned) $39,000
Expenses (incurred) 22,500
Net income $16,500
Quick Study 3-8 (10 minutes)
The answer is c.
Explanation:
The debit balance in Prepaid Insurance was reduced by $400, implying a $400 debit to Insurance Expense. The credit balance in Interest Payable increased by $800, which implies an $800 debit to Interest Expense.
Quick Study 3-9 (15 minutes)
The answer is 2.
Explanation:
Insurance premium error:
Understates expenses (and overstates assets) by $1,600
Accrued salaries error:
Understates expenses (and understates liabilities) by 1,000
Combination of errors:
Understates expenses by / $2,600Overstates assets by / $1,600
Understates liabilities by / $1,000
Quick Study 3-10 (15 minutes)
Adjusting entry / Debit / Credit1. / Accrue salaries expense / b / d
2. / Adjust the Unearned Services Revenue account to recognize earned revenue / g / c
3. / Record the earning of services revenue for which cash will be received the following period / h / c
Quick Study 3-11 (10 minutes)
Profit margin = $37,925 / $390,000 = 9.7%
Interpretation: For each one dollar that Yang Company records as revenue, it earns 9.7 cents in net income. Yang’s 9.7% is markedly lower than the competitors’ average profit margin of 15%. Thus, it must improve performance.
Quick Study 3-12A (5 minutes)
The answer is d.
Quick Study 3-13 (10 minutes)
a. Under IFRS, financial statements normally present assets from least liquid to most liquid.
b. Under IFRS, financial statements normally present liabilities from furthest from maturity to nearest to maturity.
Exercises
Exercise 3-1 (10 minutes)
1. B 4. F
2. E 5. D
3. C 6. A
Exercise 3-2 (30 minutes)
a. / Unearned Fee Revenue / 10,000Fee Revenue / 10,000
To record earned portion of fee received in advance.
b. / Wages Expense / 9,000
Wages Payable / 9,000
To record wages accrued but not yet paid.
c. / Depreciation Expense—Equipment / 19,127
Accumulated Depreciation—Equipment / 19,127
To record depreciation expense for the year.
d. / Office Supplies Expense / 5,242
Office Supplies* / 5,242
To record office supplies used ($480 + $5,349 - $587).
e. / Insurance Expense / 2,800
Prepaid Insurance** / 2,800
To record insurance coverage expired ($5,000 - $2,200).
f. / Interest Receivable / 750
Interest Revenue / 750
To record interest earned but not yet received.
g. / Interest Expense / 3,500
Interest Payable / 3,500
To record interest incurred but not yet paid.
Notes:
Office Supplies* / Prepaid Insurance**Beg. Bal. / 480 / Beg. Bal. / 5,000
Purch. / 5,349
? / Used / ? / Used
End. Bal. / 587 / End. Bal. / 2,200
Exercise 3-3 (25 minutes)
Accumulated Depreciation—Equipment / 16,000
To record depreciation expense for the year.
b. / Insurance Expense / 5,960
Prepaid Insurance* / 5,960
To record insurance coverage that expired
($7,000 - $1,040).
c. / Office Supplies Expense / 2,626
Office Supplies** / 2,626
To record office supplies used ($300 + $2,680 - $354).
d. / Unearned Fee Revenue / 5,000
Fee Revenue / 5,000
To record earned portion of fee received in advance
($10,000 x 1/2).
e. / Insurance Expense / 4,600
Prepaid Insurance / 4,600
To record insurance coverage that expired.
f. / Wages Expense / 4,000
Wages Payable / 4,000
To record wages accrued but not yet paid.
Notes:
Prepaid Insurance* / Office Supplies**Bal. Bal. / 7,000 / Beg. Bal. / 300
Purch. / 2,680
? / Used / ? / Used
End. Bal. / 1,040 / End. Bal. / 354
Exercise 3-4 (25 minutes)
a.
Apr. 30 Legal Fees Expense 2,500
Legal Fees Payable 2,500
To record accrued legal fees.
May 12 Legal Fees Payable 2,500
Cash 2,500
To pay accrued legal fees.
b.
Apr. 30 Interest Expense 2,080
Interest Payable 2,080
To record accrued interest expense (9.6% x $780,000 x 10/360) or ($6,240 x 10/30).
May 20 Interest Payable 2,080
Interest Expense 4,160
Cash 6,240
To record payment of accrued and current interest expense (9.6% x $780,000 x 20/360).
c.
Apr. 30 Salaries Expense 3,600
Salaries Payable 3,600
To record accrued salaries
($9,000 x 2/5 week).
May 3 Salaries Payable 3,600
Salaries Expense 5,400
Cash 9,000
To record payment of accrued and current salaries ($9,000 x 3/5 week).
Exercise 3-5 (15 minutes)
a. $ 1,650
b. $ 5,700
c. $10,080
d. $ 1,375
Proof:
(a) / (b) / (c) / (d)Supplies available – prior year-end / $ 300 / $1,600 / $ 1,360 / $1,375
Supplies purchased in current year / 2,100 / 5,400 / 10,080 / 6,000
Total supplies available / 2,400 / 7,000 / 11,440 / 7,375
Supplies available – current year-end / (750) / (5,700) / (1,840) / (800)
Supplies expense for current year / $1,650 / $1,300 / $ 9,600 / $6,575
Exercise 3-6 (15 minutes)
a. Adjusting entry:
2011
Dec. 31 / Wages Expense / 500Wages Payable / 500
To record accrued wages for one day.
(5 workers x $100 x 1 day)
b. Payday entry:
2012
Jan. 4 / Wages Expense / 1,500
Wages Payable / 500
Cash / 2,000
To record accrued and current wages.
Exercise 3-7 (25 minutes)
Dec. 31 Accounts Receivable 1,800
Fees Earned 1,800
To record earned but unbilled fees (30% x $6,000).
31 Unearned Fees 4,200
Fees Earned 4,200
To record earned fees collected in advance (70% x $6,000).
31 Depreciation Expense—Computers 1,500
Accumulated Depreciation—Computers 1,500
To record depreciation on computers.
31 Depreciation Expense—Office Furniture 1,750
Accumulated Depreciation—Office Furniture 1,750
To record depreciation on office furniture.
31 Salaries Expense 2,450
Salaries Payable 2,450
To record accrued salaries.
31 Insurance Expense 1,300
Prepaid Insurance 1,300
To record expired prepaid insurance.
31 Office Supplies Expense 480
Office Supplies 480
To record use of office supplies.
31 Utilities Expense 70
Utilities Payable 70
To record incurred and unpaid utility costs.
Exercise 3-8 (20 minutes)
Accrual Basis* / Cash
Basis / Accrual Basis** / Cash
Basis
Dec. 31, 2009 / $11,700 / $0 / 2009 / $ 4,500 / $16,200
Dec. 31, 2010 / 6,300 / 0 / 2010 / 5,400 / 0
Dec. 31, 2011 / 900 / 0 / 2011 / 5,400 / 0
Dec. 31, 2012 / 0 / 0 / 2012 / 900 / 0
Total / $16,200 / $16,200
EXPLANATIONS:
*Accrual asset balance equals months left in the policy x $450 per month (monthly cost is computed as $450, from $16,200 divided by 36 months).
Months Left Balance
12/31/2009 26 $11,700
12/31/2010 14 6,300
12/31/2011 2 900
12/31/2012 0 0
**Accrual insurance expense equals months covered in the year x $450 per month.
Months Covered / Expense2009 / 10 / $ 4,500
2010 / 12 / 5,400
2011 / 12 / 5,400
2012 / 2 / 900
$16,200
Exercise 3-9 (10 minutes)
a. $5,390 / $44,830 = 12.0%
b. $87,644 / $398,954 = 22.0%
c. $93,385 / $257,082 = 36.3%
d. $55,234 / $1,458,999 = 3.8%
e. $70,158 / $435,925 = 16.1%
Analysis and Interpretation: Company c has the highest profitability according to the profit margin ratio. Company c earns 36.3 cents in net income for each one dollar of net sales recorded.
Exercise 3-10A (25 minutes)
a. Initial credit recorded in the Unearned Fees account:
July 1 Cash 2,000
Unearned Fees 2,000
Received fees for work to be done.
6 Cash 8,400
Unearned Fees 8,400
Received fees for work to be done.
12 Unearned Fees 2,000
Fees Earned 2,000
Completed work for customer.
18 Cash 7,500
Unearned Fees 7,500
Received fees for work to be done.
27 Unearned Fees 8,400
Fees Earned 8,400
Completed work for customer.
31 No adjusting entries required.
b. Initial credit recorded in the Fees Earned account:
July 1 Cash 2,000
Fees Earned 2,000
Received fees for work to be done.
6 Cash 8,400
Fees Earned 8,400
Received fees for work to be done.
12 No entry required.
18 Cash 7,500
Fees Earned 7,500
Received fees for work to be done.
27 No entry required.
31 Fees Earned 7,500
Unearned Fees 7,500
Adjusted to reflect unearned fees for unfinished job.
Exercise 3-10A - (Continued)
c. Under the first method (and using entries from a):
Unearned Fees = $2,000 + $8,400 - $2,000 + $7,500 - $8,400 = $7,500
Fees Earned = $2,000 + $8,400 = $10,400
Under the second method (and using entries from b):
Unearned Fees = $7,500
Fees Earned = $2,000 + $8,400 + $7,500 - $7,500 = $10,400
[Note: Both procedures yield identical results in the financial statements.]
Exercise 3-11A (30 minutes)
a.
Dec. 1 Supplies Expense 3,000
Cash 3,000
Purchased supplies.
b.
Dec. 2 Insurance Expense 1,440
Cash 1,440
Paid insurance premiums.
c.
Dec. 15 Cash 12,000
Remodeling Fees Earned 12,000
Received fees for work to be done.
d.
Dec. 28 Cash 3,600
Remodeling Fees Earned 3,600
Received fees for work to be done.
e.
Dec. 31 Supplies 1,920
Supplies Expense 1,920
Adjust expenses for unused supplies.
f.
Dec. 31 Prepaid Insurance ($1,440 - $240) 1,200