E2-7 (Accounting Principles—Comprehensive) Presented below are a number of business transactions
that occurred during the current year for Fresh Horses, Inc.
Instructions
In each of the situations, discuss the appropriateness of the journal entries in terms of generally accepted
accounting principles.
(a) The president of Fresh Horses, Inc. used his expense account to purchase a new Suburban solely
for personal use. The following journal entry was made.
Miscellaneous Expense 29,000
Cash 29,000
(b) Merchandise inventory that cost $620,000 is reported on the balance sheet at $690,000, the expected
selling price less estimated selling costs. The following entry was made to record this increase
in value.
Merchandise Inventory 70,000
Revenue 70,000
(c) The company is being sued for $500,000 by a customer who claims damages for personal injury
apparently caused by a defective product. Company attorneys feel extremely confident that the
company will have no liability for damages resulting from the situation. Nevertheless, the company
decides to make the following entry.
Loss from Lawsuit 500,000
Liability for Lawsuit 500,000
(d) Because the general level of prices increased during the current year, Fresh Horses, Inc. determined
that there was a $16,000 understatement of depreciation expense on its equipment and decided to record it in its accounts. The following entry was made.
Depreciation Expense 16,000
Accumulated Depreciation 16,000
(e) Fresh Horses, Inc. has been concerned about whether intangible assets could generate cash in case
of liquidation. As a consequence, goodwill arising from a purchase transaction during the current
year and recorded at $800,000 was written off as follows.
Retained Earnings 800,000
Goodwill 800,000
(f) Because of a “fire sale,” equipment obviously worth $200,000 was acquired at a cost of $155,000.
The following entry was made.
Equipment 200,000
Cash 155,000
Revenue 45,000
(a) This entry violates the economic entity assumption. This assumption in accounting indicates that economic activity can be identified with a particular unit of accountability. In this situation, the company erred by charging this cost to the wrong economic entity.
(b) The historical cost principle indicates that assets and liabilities are accounted for on the basis of cost. If we were to select sales value, for example, we would have an extremely difficult time in attempting to establish a sales value for a given item without selling it. It should further be noted that the revenue recognition principle provides the answer to when revenue should be recognized. Revenue should be recognized when (1) realized or realizable and (2) earned. In this situation, an earnings process has definitely not taken place.
(c)Probably the company is too conservative in its accounting for this transaction. The matching principle indicates that expenses should be allocated to the appropriate periods involved. In this case, there appears to be a high uncertainty that the company will have to pay. FASB Statement No. 5 requires that a loss should be accrued only (1)when it is probable that the company would lose the suit and
(2)the amount of the loss can be reasonably estimated. (Note to instructor: The student will probably be unfamiliar with FASB Statement No.5. The purpose of this question is to develop some decision framework when the probability of a future event must be assumed.)
(d) At the present time, accountants do not recognize price-level adjust-ments in the accounts. Hence, it is misleading to deviate from the cost principle because conjecture or opinion can take place. It should also be noted that depreciation is not so much a matter of valuation as it is a means of cost allocation. Assets are not depreciated on the basis of a decline in their fair market value, but are depreciated on the basis of systematic charges of expired costs against revenues. (Note to instructor: It might be called to the students’ attention that the FASB does encourage supplemental disclosure of price-level information.)
(e) Most accounting methods are based on the assumption that the busi-ness enterprise will have a long life. Acceptance of this assumption provides credibility to the historical cost principle, which would be of limited usefulness if liquidation were assumed. Only if we assume some permanence to the enterprise is the use of depreciation and amortization policies justifiable and appropriate. Therefore, it is incor-rect to assume liquidation as Fresh Horses, Inc. has done in this situation. It should be noted that only where liquidation appears imminent is the going concern assumption inapplicable.
(f) The answer to this situation is the same as (b).
E3-5 (Adjusting Entries) The ledger of Duggan Rental Agency on March 31 of the current year includes
the following selected accounts before adjusting entries have been prepared.
Debit Credit
Prepaid Insurance $ 3,600
Supplies 2,800
Equipment 25,000
Accumulated Depreciation—Equipment $ 8,400
Notes Payable 20,000
Unearned Rent Revenue 9,300
Rent Revenue 60,000
Interest Expense –0–
Wage Expense 14,000
An analysis of the accounts shows the following.
1. The equipment depreciates $250 per month.
2. One-third of the unearned rent was earned during the quarter.
3. Interest of $500 is accrued on the notes payable.
4. Supplies on hand total $850.
5. Insurance expires at the rate of $300 per month.
Instructions
Prepare the adjusting entries at March 31, assuming that adjusting entries are made quarterly. Additional
accounts are: Depreciation Expense; Insurance Expense; Interest Payable; and Supplies Expense. (Omit
explanations.)
WATTEAU CO.
TRIAL BALANCE
JUNE 30, 2007
Debit Credit
Cash $ 2,870
Accounts Receivable $ 3,231
Supplies 800
Equipment 3,800
Accounts Payable 2,666
Unearned Service Revenue 1,200
Common Stock 6,000
Retained Earnings 3,000
Service Revenue 2,380
Wages Expense 3,400
Office Expense 940
$13,371 $16,916
(L0 5)
1. / Depreciation Expense...... / 750Accumulated Depreciation – Equipment...... / 750
2. / Unearned Rent Revenue...... / 3,100
Rent Revenue...... / 3,100
3. / Interest Expense...... / 500
Interest Payable...... / 500
4. / Supplies Expense...... / 1,950
Supplies...... / 1,950
5. / Insurance Expense...... / 900
Prepaid Insurance...... / 900
Instructions
(a) Construct T-accounts and enter the balances shown.
(b) Prepare adjusting journal entries for the following and post to the T-accounts. (Omit explanations.)
Open additional T-accounts as necessary. (The books are closed yearly on December 31.)
(1) Bad debts are estimated to be $1,400.
(2) Furniture and equipment is depreciated based on a 6-year life (no salvage value).
(3) Insurance expired during the year $2,550.
(4) Interest accrued on notes payable $3,360.
(5) Sales salaries earned but not paid $2,400.
(6) Advertising paid in advance $700.
(7) Office supplies on hand $1,500, charged to Office Expense when purchased.
(c) Prepare closing entries and post to the accounts.
(a), (b), (c)
Cash / Accounts Receivable / Allow. for Doubtful Accts.Bal. / 18,500 / Bal. / 42,000 / Bal. / 700
Adj. / 1,400
Inventory / Furniture & Equipment / Accum. Depr. of F. & E.
Bal. / 80,000 / Bal. / 84,000 / Bal. / 35,000
Adj. / 14,000
Prepaid Insurance / Notes Payable / Admin. Salaries Expense
Bal. / 5,100 / Adj. / 2,550 / Bal. / 28,000 / Bal. / 65,000 / Cls. / 65,000
Common Stock / Sales / Insurance Expense
Bal. / 80,600 / Cls. / 600,000 / Bal. / 600,000 / Adj. / 2,550 / Cls. / 2,550
Sales Salaries Expense / Advertising Expense / Interest Expense
Bal. / 50,000 / Cls. / 52,400 / Bal. / 6,700 / Adj. / 700 / Adj. / 3,360 / Close / 3,360
Adj. / 2,400 / Close / 6,000
52,400 / 52,400 / 6,700 / 6,700
Bad Debt Expense / Office Expense / Prepaid Advertising Expense
Adj. / 1,400 / Cls. / 1,400 / Bal. / 5,000 / Adj. / 1,500 / Adj. / 700
Close / 3,500
5,000 / 5,000
Interest Payable / Depr. Exp.—Furn. & Equip. / Income Summary
Adj. / 3,360 / Adj. / 14,000 / Cls. / 14,000 / Exp. / 546,210 / Sales / 600,000
Inc. / 53,790
600,000 / 600,000
Office Supplies / Salaries Payable
Adj. / 1,500 / Adj. / 2,400
Retained Earnings / Cost of Goods Sold
Bal. / 10,000 / Bal. / 398,000 / Cls. / 398,000
Inc. / 53,790
Bal. / 63,790
(b) / -1-
Bad Debts Expense...... / 1,400
Allowance for Doubtful Accounts...... / 1,400
-2-
Depreciation Expense—Furniture and
Equipment ($84,000 ÷ 6)...... /
14,000
Accum. Depr.—Furniture and Equipment...... / 14,000
-3-
Insurance Expense...... / 2,550
Prepaid Insurance...... / 2,550
-4-
Interest Expense...... / 3,360
Interest Payable...... / 3,360
-5-
Sales Salaries Expense...... / 2,400
Salaries Payable...... / 2,400
-6-
Prepaid Advertising Expense...... / 700
Advertising Expense...... / 700
-7-
Office Supplies...... / 1,500
Office Expense...... / 1,500
(c) / Dec. 31
Sales / 600,000
Income Summary...... / 600,000
Dec. 31
Income Summary...... / 546,210
Cost of Goods Sold...... / 398,000
Advertising Expense...... / 6,000
Administrative Salaries Expense...... / 65,000
Sales Salaries Expense...... / 52,400
Office Expense...... / 3,500
Insurance Expense...... / 2,550
Bad Debt Expense...... / 1,400
Depreciation Expense—Furniture and
Equipment...... /
14,000
Interest Expense...... / 3,360
Dec. 31
Income Summary...... / 53,790
Retained Earnings...... / 53,790
Instructions
(a) For each plant:
(2) Compute equivalent units of production for materials and for conversion costs.
(b) Prepare the production cost report for Plant A for June 2005.
(a)(1)Physical units
R12Refrigerators / F24
Freezers
Units to be accounted for
Work in process, June 1
Started into production
Total units
Units accounted for
Transferred out
Work in process, June 30
Total units / 0
20,000
20,000
18,000
2,000
20,000 / 0
20,000
20,000
17,000
3,000
20,000
(2)Equivalent units
R12 RefrigeratorsMaterials / Conversion
Costs
Units transferred out
Work in process, June 30
(2,000 X 100%)
(2,000 X 70%)
Total equivalent units / 18,000
2,000
00,000
20,000 / 18,000
1,400
19,400
F24 Freezers
Materials / Conversion
Costs
Units transferred out
Work in process, June 30
(3,000 X 100%)
(3,000 X 50%)
Total equivalent units / 17,000
3,000
00,000
20,000 / 17,000
1,500
18,500
(3)Unit costs
Plant A / Plant BR12
Refrigerators / F24
Freezers
Materials($840,000 ÷ 20,000)
($700,000 ÷ 20,000)
Conversion costs($620,800* ÷ 19,400)
($555,000** ÷ 18,500)
Total / $42
32
000
$74 / $35
30
$65
*$200,800 + $420,000
**$236,000 + $319,000
Plant A
(4)R12 Refrigerators
Costs accounted for
Transferred out (18,000 X $74)$1,332,000
Work in process
Materials (2,000 X $42)$84,000
Conversion costs
(1,400 X $32.00)44,800 128,800
Total costs$1,460,800
Plant B
F24 Freezers
Costs accounted for
Transferred out (17,000 X $65)$1,105,000
Work in process
Materials (3,000 X $35)$105,000
Conversion costs
(1,500 X $30) 45,000 150,000
Total costs$1,255,000
(b)STEIN CORPORATION
Stamping Department—Plant A
Production Cost Report
For the Month Ended June 30, 2007
Equivalent UnitsQuantities / Physical
Units / Materials / Conversion
Costs
(Step 1) / (Step 2)
Units to be accounted for
Work in process, June 1
Started into production
Total units
Units accounted for
Transferred out / 0
20,000
20,000
18,000 / 18,000 / 18,000
Work in process, June 30 / 2,000 / 2,000 / 1,400 / (2,000 X 70%)
Total units / 20,000 / 20,000 / 19,400
Costs / Materials / Conversion
Costs / Total
Unit costs (Step 3)
Costs in June
Equivalent units
Unit costs [(a) ÷ (b)]
Costs to be accounted for
Work in process, June 1
Started into production
Total costs / (a)
(b) / $840,000
20,000
$42 / $620,800
19,400
$32 / $1,460,800
$74
$0
1,460,800
$1,460,800
Cost Reconciliation Schedule (Step 4)
Costs accounted for
Transferred out (18,000 X $74)
Work in process, June 30
Materials (2,000 X $42)
Conversion costs (1,400 X $32)
Total costs / $84,000
44,800 / $1,332,000
128,800
$1,460,800