chapter 4

The accounting cycle:
accruals and deferrals

OVERVIEW OF EXERCISES, PROBLEMS, CASES, AND INTERNET ASSIGNMENT

Exercises /
Topic / Learning
Objectives /
Characteristics
4–1 / Accounting terminology / 1–9 / Conceptual
4–2 / Effects of adjusting entries / 1–6, 9 / Conceptual
4–3 / Preparing adjusting entries / 1–7 / Mechanical
4–4 / Evaluating balance sheet accounts / 1–7 / Conceptual, real – Carnival Corporation
4–5 / Preparing adjusting entries / 1–7 / Mechanical, conceptual
4–6 / Evaluating balance sheet accounts / 1, 2, 4 / Conceptual, mechanical, real – American Airlines
4–7 / Preparing adjusting entries / 1–6, 9 / Mechanical, conceptual
4–8 / Notes payable and interest / 1, 2, 5 / Mechanical
4–9 / Adjustments and the balance sheet / 1–7, 9 / Mechanical, conceptual
4–10 / Concept of materiality / 8 / Conceptual
4–11 / Accounting principles / 1–8 / Conceptual
4-12 / Examining an annual report / 1, 2 / Conceptual, real – Tootsie Roll Industries, Inc.
Problems
4–1 / Preparing adjusting entries / 1–7 / Mechanical, conceptual
4–2 / Preparing and analyzing the effects of adjusting entries / 1–6, 9 / Mechanical, analytical, conceptual
4–3 / Analysis of adjusted data / 1–7, 9 / Conceptual, analytical
4–4 / Preparing adjusting entries from a trial balance / 1–7, 9 / Mechanical, conceptual
4–5 / Preparing adjusting entries from a trial balance / 1–7, 9 / Mechanical, conceptual, analytical
4-6 / Preparing adjusting entries from a trial balance / 1–7,9 / Mechanical, conceptual, analytical
4–7 / Understanding the effects of errors / 1–7, 9 / Conceptual, analytical
Cases
4–1 / Judgment and adjusting entries / 1–7 / Analytical, mechanical, communication
4–2 / Materiality / 8 / Conceptual, communication, real—Avis Rent-a-Car
Business Week Assignment
4–3 / Business Week assignment / 3, 4, 6, 7 / Conceptual, group, mechanical, real—NetJets, Inc., and Berkshire Hathaway
Internet Assignment /
Topic / Learning
Objectives /
Characteristics
4–1 / Identifying accounts requiring adjusting entries / 1–6 / Internet, real—Hershey Corporation

DESCRIPTIONS OF PROBLEMS, CASES, AND INTERNET ASSIGNMENT

Below are brief descriptions of each problem, case, and Internet assignment. These descriptions are accompanied by the estimated time (in minutes) required for completion and by a difficulty rating. The time estimates assume use of the partially filled-in working papers.

Problems

4–1 / Florida Palms Country Club
Students are required to make end-of-period adjusting entries and identify the type of each adjusting entry made. They must also distinguish between an asset’s fair market value and its net book value.
/ 20 Easy
4–2 / Enchanted Forest
Students are required to make end-of-period adjusting entries, identify the type of each adjusting entry made, and analyze the effect of each adjustment on the income statement and balance sheet. In addition, they must compute annual interest expense and determine an asset’s net book value.
/ 40 Medium
4–3 / Gunflint Adventures
Given selected account balances from an adjusted trial balance and other related data, students are required to answer questions about the adjusted amounts and to reconstruct the adjusting entries.
/ 25 Strong
4–4 / Campus Theater
Students are required to make end-of-period adjusting entries, and draw conclusions related to depreciation estimates and profitability.
/ 30 Medium
4–5 / Ken Hensley Enterprises, Inc.
Students are required to make end-of-period adjusting entries, compute income, and analyze changes in various accounts. / 50 Strong
4-6 / Stillmore Investigations
Students are required to make end-of-period adjusting entries, prepare an adjusted trial balance, compute income, and analyze changes in various accounts. / 60 Strong
4–7 / Coyne Corporation
Students are to analyze and interpret the effects of various errors on elements of the financial statements.
/ 20 Strong

Cases

4–1 / Property Management Professionals
Students are to evaluate several situations and explain whether a year-end adjusting entry is needed. Students must also explain the effects of any required adjustments.
/ 30 Medium
4–2 / Materiality and Avis Rent-a-Car
Discusses the concept of materiality. The purchase of automobiles by Avis for its rental fleet is used to illustrate how the cumulative effect of many immaterial transactions can become material.
/ 25 Medium

Business Week Assignment

4–3 / Business Week Assignment
Students are asked to account for a prepaid lease agreement of a private jet. They must also consider justifications for the extremely high cost of the lease. / 15 Medium

Internet Assignment

4–1 / Hershey Corporation
Students are asked to identify accounts in Hershey’s balance sheet that were most likely to have been involved in the company’s year-end adjusting entry process.
/ 15 Easy

SUGGESTED ANSWERS TO DISCUSSION QUESTIONS

1. / The purpose of making adjusting entries is to recognize certain revenue and expenses that are not properly measured in the course of recording daily business transactions. These entries help achieve the goals of accrual accounting by recognizing revenue when it is earned and recognizing expenses when the related goods or services are used.
2. / The only transactions that require end-of-period adjusting entries are those that affect the revenue or expenses of more than one accounting period. Adjusting entries then are needed to apportion the revenue or expense among the affected accounting periods.
3. / All adjusting entries affect both an income statement account and a balance sheet account. Every adjusting entry involves the recognition of either revenue or expense. Revenue and expenses represent changes in owners’ equity, which appears in the balance sheet. However, owners’ equity cannot change by itself; there must also be a corresponding change in either assets or liabilities.
4. / Making adjusting entries requires a better understanding of accrual accounting than does the recording of routine business transactions because there is no “external evidence” (such as bills or invoices) indicating the need for adjusting entries. Adjusting entries are necessary to reflect recorded costs that have expired and recorded revenue that has been earned or to recognize previously unrecorded business activities. Thus, the need for adjusting entries is determined by the accountant’s understanding of the concepts of accrual accounting, not by external source documents.
5. / Under accrual accounting, an expense is defined as the cost of goods and services used in the effort to generate revenue. Thus, an expense is incurred when the related goods and services are used, not when the expense is paid. A 12-month insurance policy represents insurance coverage that is used up over a 12-month period. The cost of such a policy should be debited to an asset account and gradually recognized as an expense over the 12 months that the policy is in force.
6. / Accrual accounting requires that revenue be recognized in the accounting records when it is earned. If revenue has been earned, but not yet recorded in the accounts, an adjusting entry should be made to include this revenue in the income of the current period. This entry will credit a revenue account; as the revenue has not yet been collected, the debit will be to an account receivable.
7. / The term, unearned revenue, describes amounts that have been collected from customers in advance and that have not yet been earned. As the company has an obligation to render services to these customers or to refund their advance payments, unearned revenue appears in the liability section of the balance sheet. As services are performed for these customers, the liability is reduced. Therefore, an adjusting entry is made transferring the balance of the unearned revenue account into a revenue account.
8. / Salaries Expense / 16,000
Salaries Payable / 16,000
To record salaries expense and related liability to employees for the last four days of the year (4¤5 ´ $20,000 = $16,000).
9. / In the income statement, the Insurance Expense account will be understated; hence total expenses will be understated, and net income will be overstated. In the balance sheet, the asset account, Unexpired Insurance, will be overstated, as will the amount for total assets. Offsetting this overstatement of assets will be an overstatement of retained earnings; hence owners’ equity will be overstated.
10. / Materiality refers to the relative importance of an item or an event to the users of financial statements. An item is “material” if knowledge of it might reasonably influence the decisions of financial statement users.
If an item is not material, by definition it is not relevant to decision makers. Therefore, the item may be treated in the most convenient and economical manner by the preparer of the financial statements. Thus, the concept of materiality permits departures from other generally accepted accounting principles in accounting for items that are not material.
11. / The concept of materiality permits accountants to handle items that are unlikely to influence the decisions of users of the accounting information in the most convenient and economical manner. Charging the costs of low-priced and short-lived assets immediately to an expense is not likely to affect the decisions of users of the financial statements. On the other hand, accounting for these items as assets and recording periodic depreciation would require time, effort, and cost. Thus, low-priced and short-lived assets are routinely charged to an expense, because charging them to asset accounts simply is “not worth the bother.”

Solutions to Exercises

Ex 4–1 / a. / Book value
b. / Materiality
c. / Matching principle
d. / Unrecorded revenue
e. / Adjusting entries
f. / Unearned revenue
g. / Prepaid expenses
h. / None (This is an example of “depreciation expense.”)
Ex. 4–2 / Income Statement / Balance Sheet
Adjusting Entry /
Revenue /
- /
Expenses /
= / Net Income /
Assets /
= /
Liabilities /
+ / Owners’
Equity
a / NE / I / D / D / NE / D
b / NE / I / D / NE / I / D
c / I / NE / I / I / NE / I
d / NE / I / D / NE / I / D
e / NE / I / D / D / NE / D
f / I / NE / I / NE / D / I
Ex. 4–3 / a. / Rent Expense / 240,000
Prepaid Rent / 240,000
To record rent expense for May ($1,200,000 ¸ 5 months = $240,000 per month).
b. / Unearned Ticket Revenue / 148,800
Ticket Revenue / 148,800
To record earning portion of season ticket revenue relating to May home games.
Ex. 4–4 / a. / Prepaid Advertising is reported in the balance sheet as an asset. Customer Deposits are reported in the balance sheet as liabilities.
b. / Advertising Expense / 18,000,000
Prepaid Advertising / 18,000,000
To record the mailing of brochures costing $18 million to print.
c. / Customer Deposits / 90,000,000
Cruise Revenue / 90,000,000
To record revenue earned for voyages completed.
d. / The adjusting entry that results in the most significant expense in the company’s income statement is the recording of depreciation expense on its cruise ships.
Note to the instructor: In a recent income statement the company reported depreciation expense in excess of $300,000,000.
Ex. 4–5 / a. / (1) / Interest Expense / 375
Interest Payable / 375
$50,000 x 9% annual rate x 1/12 = $375.
(2) / Accounts Receivable / 10,000
Consulting Fees Earned / 10,000
To record ten days of unbilled consulting fees at $1,000 per day.
b. / $2,250 ($50,000 x 9% x 6/12 = $2,250)
c. / $15,000 ($25,000 - $10,000 earned in December, 2005)
Ex. 4–6 / a. / At the time cash is collected by American Airlines for advance ticket sales, the entire amount is accounted for as unearned revenue. The liability created represents the deferral (or the postponement) of earned revenue until flight services are actually provided to passengers.
b. / Airlines normally reduce the balance of this liability account by converting it to passenger revenue as flight services are provided. On some occasions, however, the liability may be reduced as a result of making cash refunds to customers due to cancellations.
c. / Air Traffic Liability / 200,000
Passenger Revenue Earned / 200,000
To record passenger revenue earned from advance ticket sales for flights completed.
Ex. 4–7 / a. 1. / Interest Expense / 1,200
Interest Payable / 1,200
To record interest accrued on bank loan during December.
2. / Depreciation Expense: Office Building / 1,100
Accumulated Depreciation: Office Building / 1,100
To record depreciation on office building ($330,000 ¸ 25 years ´ 1¤12 = $1,100).
3. / Accounts Receivable / 64,000
Marketing Revenue Earned / 64,000
To record accrued Marketing revenue earned in December.
4. / Insurance Expense / 150
Prepaid Insurance / 150
To record insurance expense (1,800 ¸ 12 months = $150).
5. / Unearned Revenue / 3,500
Marketing Revenue Earned / 3,500
To record portion of unearned revenue that had become earned in December.
6. / Salaries Expense / 2,400
Salaries Payable / 2,400
To record accrued salaries in December.
b. / $62,650 ($64,000 + $3,500 - $1,200 - $1,100 - $150 - $2,400).
Ex. 4–8 / a. / The total interest expense over the life of the note is $5,400 ($120,000 ´ .09 ´ 6¤12 = $5,400).
The monthly interest expense is $900 ($5,400 ¸ 6 = $900).
b. / The liability to the bank at December 31, 2005, is $121,800 (Principal, $120,000 + $1,800 accrued interest).