study objectives
After studying this chapter, you should be able to:
1 Explain the revenue recognition principle and the expense
recognition principle.
2 Differentiate between the cash basis and the accrual basis of
accounting.
3 Explain why adjusting entries are needed, and identify the
major types of adjusting entries.
4 Prepare adjusting entries for deferrals.
5 Prepare adjusting entries for accruals.
6 Describe the nature and purpose of the adjusted trial balance.
7 Explain the purpose of closing entries.
8 Describe the required steps in the accounting cycle.
9 Understand the causes of differences between net
income and cash provided by operating activities.
chapter
ACCRUAL ACCOUNTING
CONCEPTS
4
● Scan Study Objectives
● Read Feature Story
● Scan Preview
● Read Text and Answer
p. 175 p. 180 p. 185 p. 189
● Work Using the Decision Toolkit
● Review Summary of Study Objectives
● Work Comprehensive p. 197
● Answer Self-Test Questions
● Complete Assignments
● Go to WileyPLUS for practice and tutorials
● Read A Look at IFRS p. 224
● the navigator
Do it!
Do it!
✓
162
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feature story
163
The accuracy of the financial reporting system depends on answers to a few fundamental questions. At
what point has revenue been earned? At what point
is the earnings process complete? When have expenses really been incurred?
During the 1990s, the stock prices of dot-com companies boomed. Many dot-com companies earned most
of their revenue from selling advertising
space on their websites. To boost reported revenue, some dot-coms began
swapping website ad space. Company
A would put an ad for its website on company B’s website, and company B would put an ad for its website on
company A’s website. No money ever changed hands,
but each company recorded revenue (for the value of
the space that it gave up on its site). This practice did
little to boost net income and resulted in no additional
cash flow—but it did boost reported revenue. Regulators eventually put an end to the practice.
Another type of transgression results from companies recording revenue or expenses in the wrong year.
In fact, shifting revenues and expenses is one of the
most common abuses of financial accounting. Xerox
admitted reporting billions of dollars of lease revenue
in periods earlier than it should have been reported.
And WorldCom stunned the financial markets with its
admission that it had boosted net income by billions
of dollars by delaying the recognition of expenses until later years.
Unfortunately, revelations such as
these have become all too common in
the corporate world. It is no wonder that
the U.S. Trust Survey of affluent Americans reported that 85 percent of its respondents believed that there should be tighter regulation of financial disclosures, and 66 percent said they did not trust
the management of publicly traded companies.
Why did so many companies violate basic financial
reporting rules and sound ethics? Many speculate that
as stock prices climbed, executives were under increasing pressure to meet higher and higher earnings expectations. If actual results weren’t as good as hoped for,
some gave in to temptation and “adjusted” their numbers to meet market expectations.
● Cooking the Books? (p. 166)
● Reporting Revenue Accurately (p. 167)
● Turning Gift Cards into Revenue (p. 174)
● Cashing In on Accrual Accounting (p. 178)
INSIDE CHAPTER 4 . . .
W HAT WAS
YOU R P ROFIT?
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Accrual Accounting Concepts
As indicated in the Feature Story, making adjustments is necessary to avoid misstatement of revenues and
expenses such as those at Xerox and WorldCom. In this chapter, we introduce you to the accrual accounting
concepts that make such adjustments possible.
The organization and content of the chapter are as follows.
Timing Issues
Most businesses need immediate feedback about how well they are doing. For
example, management usually wants monthly reports on financial results, most
large corporations are required to present quarterly and annual financial statements to stockholders, and the Internal Revenue Service requires all businesses
to file annual tax returns. Accounting divides the economic life of a business
into artificial time periods. As indicated in Chapter 2, this is the periodicity
assumption. Accounting time periods are generally a month, a quarter, or
a year.
Many business transactions affect more than one of these arbitrary time periods. For example, a new building purchased by Citigroup or a new airplane
purchased by Delta Air Lines will be used for many years. It doesn’t make
sense to expense the full cost of the building or the airplane at the time of
purchase because each will be used for many subsequent periods. Instead, we
determine the impact of each transaction on specific accounting periods.
Determining the amount of revenues and expenses to report in a given accounting period can be difficult. Proper reporting requires an understanding of
the nature of the company’s business. Two principles are used as guidelines: the
revenue recognition principle and the expense recognition principle.
THE REVENUE RECOGNITION PRINCIPLE
The revenue recognition principle requires that companies recognize revenue
in the accounting period in which it is earned. In a service company, revenue
is considered to be earned at the time the service is performed. To illustrate, assume Conrad Dry Cleaners cleans clothing on June 30, but customers do not
claim and pay for their clothes until the first week of July. Under the revenue
recognition principle, Conrad earns revenue in June when it performs the service, not in July when it receives the cash. At June 30, Conrad would report a
receivable on its balance sheet and revenue in its income statement for the service performed. The journal entries for June and July would be as follows.
preview of chapter 4
• Revenue recognition
principle
• Expense recognition
principle
• Accrual versus cash
basis of accounting
Timing Issues
• Types of adjusting
entries
• Adjusting entries for
deferrals
• Adjusting entries for
accruals
• Summary of basic
relationships
The Basics of
Adjusting Entries
• Preparing the
adjusted trial balance
• Preparing financial
statements
The Adjusted Trial
Balance and Financial
Statements
• Preparing closing
entries
• Preparing a postclosing trial balance
• Summary of the
accounting cycle
Closing the Books
• Earnings management
• Sarbanes-Oxley
Quality of Earnings
164
1
Explain the revenue
recognition principle and
the expense recognition
principle.
Helpful Hint An accounting time
period that is one year long is
called a fiscal year.
Revenue should be recognized in the accounting
period in which it is earned
(generally when service is
performed).
Revenue Recognition
Customer
requests
service
Service
performed
Cash
received
study objective
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June Accounts Receivable xxx
Service Revenue xxx
July Cash xxx
Accounts Receivable xxx
THE EXPENSE RECOGNITION PRINCIPLE
In recognizing expenses, a simple rule is followed: “Let the expenses follow the
revenues.” Thus, expense recognition is tied to revenue recognition. Applied to
the preceding example, this means that the salary expense Conrad incurred in
performing the cleaning service on June 30 should be reported in the same period in which it recognizes the service revenue. The critical issue in expense
recognition is determining when the expense makes its contribution to revenue.
This may or may not be the same period in which the expense is paid. If Conrad does not pay the salary incurred on June 30 until July, it would report salaries
payable on its June 30 balance sheet.
The practice of expense recognition is referred to as the expense recognition principle (often referred to as the matching principle). It dictates that
efforts (expenses) be matched with results (revenues). Illustration 4-1 shows
these relationships.
Timing Issues 165
DECISION TOOLKIT
DECISION CHECKPOINTS TOOL TO USE FOR DECISION HOW TO EVALUATE RESULTS
At what point should the company
record revenue?
Need to understand the nature of
the company’s business
Record revenue when earned. A
service business earns revenue
when it performs a service.
Recognizing revenue too early
overstates current period revenue;
recognizing it too late understates
current period revenue.
INFO NEEDED FOR DECISION
Revenue and Expense
Recognition
In accordance with generally
accepted accounting principles
(GAAP)
Expense Recognition
Principle
Expenses matched with revenues
in the period when efforts are
expended to generate revenues
Periodicity Assumption
Economic life of business
can be divided into
artificial time periods
Revenue Recognition
Principle
Revenue recognized in
the accounting period in
which it is earned
Illustration 4-1 GAAP
relationships in revenue
and expense recognition
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166 chapter 4 Accrual Accounting Concepts
ACCRUAL VERSUS CASH BASIS OF ACCOUNTING
Accrual-basis accounting means that transactions that change a company’s financial statements are recorded in the periods in which the events occur,
even if cash was not exchanged. For example, using the accrual basis means that
companies recognize revenues when earned (the revenue recognition principle), even if cash was not received. Likewise, under the accrual basis, companies recognize expenses when incurred (the expense recognition principle),
even if cash was not paid.
An alternative to the accrual basis is the cash basis. Under cash-basis
accounting, companies record revenue only when cash is received. They
record expense only when cash is paid. The cash basis of accounting is prohibited under generally accepted accounting principles. Why? Because it
does not record revenue when earned, thus violating the revenue recognition
principle. Similarly, it does not record expenses when incurred, which violates
the expense recognition principle.
Illustration 4-2 compares accrual-based numbers and cash-based numbers.
Suppose that Fresh Colors paints a large building in 2011. In 2011, it incurs and
pays total expenses (salaries and paint costs) of $50,000. It bills the customer
$80,000, but does not receive payment until 2012. On an accrual basis, Fresh Colors reports $80,000 of revenue during 2011 because that is when it is earned. The
company matches expenses of $50,000 to the $80,000 of revenue. Thus, 2011 net
income is $30,000 ($80,000 ! $50,000). The $30,000 of net income reported for
2011 indicates the profitability of Fresh Colors’ efforts during that period.
If, instead, Fresh Colors were to use cash-basis accounting, it would report
$50,000 of expenses in 2011 and $80,000 of revenues during 2012. As shown in
Illustration 4-2, it would report a loss of $50,000 in 2011 and would report net
income of $80,000 in 2012. Clearly, the cash-basis measures are misleading because the financial performance of the company would be misstated for both
2011 and 2012.
DECISION TOOLKIT
DECISION CHECKPOINTS TOOL TO USE FOR DECISION HOW TO EVALUATE RESULTS
At what point should the company
record expenses?
Need to understand the nature of
the company’s business
Expenses should “follow”
revenues—that is, match the
effort (expense) with the result
(revenue).
Recognizing expenses too early
overstates current period
expense; recognizing them too
late understates current period
expense.
INFO NEEDED FOR DECISION
What motivates sales executives and finance and accounting executives to participate
in activities that result in inaccurate reporting of revenues? (See page 223.)
Cooking the Books?
Allegations of abuse of the revenue recognition principle have become all too
common in recent years. For example, it was alleged that Krispy Kreme sometimes doubled the number of doughnuts shipped to wholesale customers at the end of a quarter
to boost quarterly results. The customers shipped the unsold doughnuts back after the
beginning of the next quarter for a refund. Conversely, Computer Associates International
was accused of backdating sales—that is, saying that a sale that occurred at the beginning of one quarter occurred at the end of the previous quarter in order to achieve the
previous quarter’s sales targets.
Ethics Insight
?
International Note Although
different accounting standards are
often used by companies in other
countries, the accrual basis of
accounting is central to all of
these standards.
2
Differentiate between the
cash basis and the accrual
basis of accounting.
study objective
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The Basics of Adjusting Entries
In order for revenues to be recorded in the period in which they are earned, and
for expenses to be recognized in the period in which they are incurred, companies make adjusting entries. Adjusting entries ensure that the revenue recognition and expense recognition principles are followed.
Adjusting entries are necessary because the trial balance—the first pulling
together of the transaction data—may not contain up-to-date and complete data.
This is true for several reasons:
1. Some events are not recorded daily because it is not efficient to do so. Examples are the use of supplies and the earning of wages by employees.
The Basics of Adjusting Entries 167
| ( ) Revenue Expense Net loss $ 0 50,000 $ 50,000 |
$80,000 0 $80,000 Revenue Expense Net income |
Cash basis |
| $ 0 0 $ 0 Revenue Expense Net income |
$80,000 50,000 $30,000 Revenue Expense Net income |
Accrual basis |
| Purchased paint, painted building, paid employees PA INT Fresh Colors PA INT PA INT Bob’s Bait Barn Bob’s Bait Barn |
Received payment for work done in 2011 $ $ Bob’s Bait Barn |
Activity |
| 2011 | 2012 |
Illustration 4-2 Accrualversus cash-basis
accounting
Reporting Revenue Accurately
Until recently, electronics manufacturer Apple was required to spread the
revenues earned from iPhone sales over the two-year period following the sale of the
phone. Accounting standards required this because it was argued that Apple was obligated to provide software updates after the phone was sold. Therefore, since Apple
had service obligations after the initial date of sale, it was forced to spread the revenue
over a two-year period. However, since the company received full payment upfront, the
cash flows from iPhones significantly exceeded the revenue reported from iPhone sales
in each accounting period. It also meant that the rapid growth of iPhone sales was not
fully reflected in the revenue amounts reported in Apple’s income statement. A new accounting standard now enables Apple to report nearly all of its iPhone revenue at the
point of sale. It was estimated that 2009 revenues would have been about 17% higher,
and earnings per share would have been almost 50% higher, under the new rule.
Investor Insight
? In the past, why was it argued that Apple should spread the recognition of iPhone revenue over a two-year period, rather than recording it upfront? (See page 223.)
study objective 3
Explain why adjusting
entries are needed, and
identify the major types of
adjusting entries.
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168 chapter 4 Accrual Accounting Concepts
2. Some costs are not recorded during the accounting period because these
costs expire with the passage of time rather than as a result of recurring
daily transactions. Examples are charges related to the use of buildings and
equipment, rent, and insurance.
3. Some items may be unrecorded. An example is a utility service bill that will
not be received until the next accounting period.
Adjusting entries are required every time a company prepares financial
statements. The company analyzes each account in the trial balance to determine whether it is complete and up to date for financial statement purposes.
Every adjusting entry will include one income statement account and one
balance sheet account.
TYPES OF ADJUSTING ENTRIES
Adjusting entries are classified as either deferrals or accruals. As Illustration 4-3
shows, each of these classes has two subcategories.
International Note Internal
controls are a system of checks
and balances designed to detect
and prevent fraud and errors. The
Sarbanes-Oxley Act requires U.S.
companies to enhance their
systems of internal control.
However, many foreign companies
do not have to meet strict internal
control requirements. Some U.S.
companies believe that this gives
foreign firms an unfair advantage
because developing and maintaining
internal controls can be very
expensive.
Deferrals:
1. Prepaid expenses: Expenses paid in cash and recorded as assets before they are
used or consumed.
2. Unearned revenues: Cash received and recorded as liabilities before revenue is
earned.
Accruals:
1. Accrued revenues: Revenues earned but not yet received in cash or recorded.
2. Accrued expenses: Expenses incurred but not yet paid in cash or recorded.
| SIERRA CORPORATION Trial Balance |
October 31, 2012
Debit Credit
Cash $15,200
Supplies 2,500
Prepaid Insurance 600
Equipment 5,000
Notes Payable $ 5,000
Accounts Payable 2,500
Unearned Service Revenue 1,200
Common Stock 10,000
Retained Earnings 0
Dividends 500
Service Revenue 10,000
Salaries Expense 4,000
Rent Expense 900
$28,700 $28,700
Subsequent sections give examples of each type of adjustment. Each example
is based on the October 31 trial balance of Sierra Corporation, from Chapter 3,
reproduced in Illustration 4-4. Note that Retained Earnings, with a zero balance,
has been added to this trial balance. We will explain its use later.
We assume that Sierra Corporation uses an accounting period of one month.
Thus, monthly adjusting entries are made. The entries are dated October 31.
Illustration 4-3
Categories of adjusting
entries
Illustration 4-4 Trial
balance
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ADJUSTING ENTRIES FOR DEFERRALS
To defer means to postpone or delay. Deferrals are costs or revenues that are
recognized at a date later than the point when cash was originally exchanged.
Companies make adjusting entries for deferrals to record the portion of the deferred item that was incurred as an expense or earned as revenue during the
current accounting period. The two types of deferrals are prepaid expenses and
unearned revenues.
Prepaid Expenses
Companies record payments of expenses that will benefit more than one accounting period as assets called prepaid expenses or prepayments. When expenses are prepaid, an asset account is increased (debited) to show the service
or benefit that the company will receive in the future. Examples of common prepayments are insurance, supplies, advertising, and rent. In addition, companies
make prepayments when they purchase buildings and equipment.
Prepaid expenses are costs that expire either with the passage of time
(e.g., rent and insurance) or through use (e.g., supplies). The expiration of these
costs does not require daily entries, which would be impractical and unnecessary. Accordingly, companies postpone the recognition of such cost expirations
until they prepare financial statements. At each statement date, they make adjusting entries to record the expenses applicable to the current accounting period and to show the remaining amounts in the asset accounts.
Prior to adjustment, assets are overstated and expenses are understated.
Therefore, as shown in Illustration 4-5, an adjusting entry for prepaid expenses
results in an increase (a debit) to an expense account and a decrease
(a credit) to an asset account.
The Basics of Adjusting Entries 169
4
Prepare adjusting entries
for deferrals.
Prepaid Expenses
| Asset | |
| Credit Adjusting Entry (–) |
Unadjusted Balance |
| Expense |
| Debit Adjusting Entry (+) |
Let’s look in more detail at some specific types of prepaid expenses, beginning with supplies.
SUPPLIES. The purchase of supplies, such as paper and envelopes, results in an
increase (a debit) to an asset account. During the accounting period, the company uses supplies. Rather than record supplies expense as the supplies are used,
companies recognize supplies expense at the end of the accounting period. At
the end of the accounting period, the company counts the remaining supplies.
The difference between the unadjusted balance in the Supplies (asset) account
and the actual cost of supplies on hand represents the supplies used (an expense)
for that period.
Recall from Chapter 3 that Sierra Corporation purchased supplies costing $2,500 on October 5. Sierra recorded the purchase by increasing (debiting)
the asset Supplies. This account shows a balance of $2,500 in the October 31
trial balance. An inventory count at the close of business on October 31 reveals
that $1,000 of supplies are still on hand. Thus, the cost of supplies used is
Illustration 4-5 Adjusting
entries for prepaid expenses
Supplies used;
record supplies expense
Supplies purchased;
record asset
Oct. 31
Oct. 5
Supplies
study objective
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170 chapter 4 Accrual Accounting Concepts
$1,500 ($2,500 ! $1,000). This use of supplies decreases an asset, Supplies.
It also decreases stockholders’ equity by increasing an expense account, Supplies Expense. This is shown in Illustration 4-6.
After adjustment, the asset account Supplies shows a balance of $1,000,
which is equal to the cost of supplies on hand at the statement date. In addition, Supplies Expense shows a balance of $1,500, which equals the cost of supplies used in October. If Sierra does not make the adjusting entry, October
expenses will be understated and net income overstated by $1,500. Moreover, both assets and stockholders’ equity will be overstated by $1,500 on
the October 31 balance sheet.
INSURANCE. Companies purchase insurance to protect themselves from losses
due to fire, theft, and unforeseen events. Insurance must be paid in advance, often
for more than one year. The cost of insurance (premiums) paid in advance is
recorded as an increase (debit) in the asset account Prepaid Insurance. At the
financial statement date, companies increase (debit) Insurance Expense and
decrease (credit) Prepaid Insurance for the cost of insurance that has expired
during the period.
On October 4, Sierra Corporation paid $600 for a one-year fire insurance policy. Coverage began on October 1. Sierra recorded the payment by increasing (debiting) Prepaid Insurance. This account shows a balance of $600 in the October 31
trial balance. Insurance of $50 ($600 ” 12) expires each month. The expiration of
prepaid insurance decreases an asset, Prepaid Insurance. It also decreases stockholders’ equity by increasing an expense account, Insurance Expense.
As shown in Illustration 4-7, the asset Prepaid Insurance shows a balance of
$550, which represents the unexpired cost for the remaining 11 months of coverage. At the same time, the balance in Insurance Expense equals the insurance
cost that expired in October. If Sierra does not make this adjustment, October
expenses are understated by $50 and net income is overstated by $50. Moreover,
Debit–Credit
Analysis
Journal
Entry
Posting
Basic
Analysis
Equation
Analysis
| Oct. 5 2,500 | Oct. 31 Adj. 1,500 |
| Oct. 31 Bal. 1,000 |
Supplies
| Oct. 31 Adj. 1,500 |
| Oct. 31 Bal. 1,500 |
Supplies Expense
Debits increase expenses: debit Supplies Expense $1,500.
Credits decrease assets: credit Supplies $1,500.
| Oct. 31 | Supplies Expense Supplies (To record supplies used) |
1,500 | 1,500 |
The expense Supplies Expense is increased $1,500, and the asset
Supplies is decreased $1,500.
Assets
Supplies
–$1,500
= =
Liabilities Stockholders’ Equity +
Supplies Expense
–$1,500
(1)
Illustration 4-6
Adjustment for supplies
Insurance expired;
record insurance expense
Insurance purchased;
record asset
Oct. 4
Oct. 31
Insurance
Insurance Policy
Nov
$50
Dec
$50
Jan
$50
Feb
$50
March
$50
April
$50
May
$50
June
$50
July
$50
Aug
$50
Sept
$50
1 YEAR $600
Oct
$50
1 year
insurance
policy
$600
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DEPRECIATION. A company typically owns a variety of assets that have long lives,
such as buildings, equipment, and motor vehicles. The period of service is referred to as the useful life of the asset. Because a building is expected to provide service for many years, it is recorded as an asset, rather than an expense,
on the date it is acquired. As explained in chapter 2, companies record such assets at cost, as required by the cost principle. To follow the expense recognition
principle, companies allocate a portion of this cost as an expense during each
period of the asset’s useful life. Depreciation is the process of allocating the cost
of an asset to expense over its useful life.
Need for adjustment. The acquisition of long-lived assets is essentially a
long-term prepayment for the use of an asset. An adjusting entry for depreciation
is needed to recognize the cost that has been used (an expense) during the period
and to report the unused cost (an asset) at the end of the period. One very
important point to understand: Depreciation is an allocation concept, not a
valuation concept. That is, depreciation allocates an asset’s cost to the
periods in which it is used. Depreciation does not attempt to report the
actual change in the value of the asset.
For Sierra Corporation, assume that depreciation on the equipment is $480
a year, or $40 per month. As shown in Illustration 4-8 (page 172), rather than decrease (credit) the asset account directly, Sierra instead credits Accumulated Depreciation—Equipment. Accumulated Depreciation is called a contra asset account.
Such an account is offset against an asset account on the balance sheet. Thus, the
Accumulated Depreciation—Equipment account offsets the asset Equipment. This
account keeps track of the total amount of depreciation expense taken over the life
of the asset. To keep the accounting equation in balance, Sierra decreases stockholders’ equity by increasing an expense account, Depreciation Expense.
The balance in the Accumulated Depreciation—Equipment account will increase $40 each month, and the balance in Equipment remains $5,000.
The Basics of Adjusting Entries 171
Debit–Credit
Analysis
Journal
Entry
Basic
Analysis
Equation
Analysis
Debits increase expenses: debit Insurance Expense $50.
Credits decrease assets: credit Prepaid Insurance $50.
| Oct. 31 | Insurance Expense Prepaid Insurance (To record insurance expired) |
50 | 50 |
The expense Insurance Expense is increased $50, and the asset
Prepaid Insurance is decreased $50.
Assets
Prepaid Insurance
!$50
(2)
= =
Liabilities Stockholders’ Equity +
Insurance Expense
!$50
Equation
Analysis
Posting
Prepaid Insurance Insurance Expense
| Oct. 4 600 | Oct. 31 Adj. 50 |
| Oct. 31 Bal. 550 |
| Oct. 31 Adj. 50 |
| Oct. 31 Bal. 50 |
Illustration 4-7
Adjustment for insurance
Depreciation recognized;
record depreciation expense
Equipment purchased;
record asset
Oct. 2
Oct. 31
Depreciation
Equipment
Oct
$40
Nov
$40
Dec
$40
Jan
$40
Feb
$40
March
$40
April
$40
May
$40
June
$40
July
$40
Aug
$40
Sept
$40
Depreciation = $480/year
as the accounting equation shows, both assets and stockholders’ equity will be
overstated by $50 on the October 31 balance sheet.
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172 chapter 4 Accrual Accounting Concepts
Statement presentation. As noted above, Accumulated Depreciation—
Equipment is a contra asset account. It is offset against Equipment on the
balance sheet. The normal balance of a contra asset account is a credit. A
theoretical alternative to using a contra asset account would be to decrease
(credit) the asset account by the amount of depreciation each period. But using
the contra account is preferable for a simple reason: It discloses both the original
cost of the equipment and the total cost that has expired to date. Thus, in the
balance sheet, Sierra deducts Accumulated Depreciation—Equipment from the
related asset account, as shown in Illustration 4-9.
Book value is the difference between the cost of any depreciable asset and
its related accumulated depreciation. In Illustration 4-9, the book value of the
equipment at the balance sheet date is $4,960. The book value and the fair value
of the asset are generally two different values. As noted earlier, the purpose of
depreciation is not valuation but a means of cost allocation.
Depreciation expense identifies the portion of an asset’s cost that expired
during the period (in this case, in October). The accounting equation shows that
without this adjusting entry, total assets, total stockholders’ equity, and net income are overstated by $40 and depreciation expense is understated by $40.
Illustration 4-10 summarizes the accounting for prepaid expenses.
Unearned Revenues
Companies record cash received before revenue is earned by increasing (crediting) a
liability account called unearned revenues. Items like rent, magazine subscriptions,
Debit–Credit
Analysis
Journal
Entry
Posting
Basic
Analysis
| Oct. 31 Adj. 40 |
| Oct. 31 Bal. 40 |
Accumulated Depreciation—Equipment
| Oct. 31 Adj. 40 |
| Oct. 31 Bal. 40 |
Depreciation Expense
| Oct. 2 5,000 |
| Oct. 31 Bal. 5,000 |
Equipment
Debits increase expenses: debit Depreciation Expense $40.
Credits increase contra assets: credit Accumulated
Depreciation—Equipment $40.
| Oct. 31 | Depreciation Expense Accumulated Depreciation— Equipment (To record monthly depreciation) |
40 | 40 |
The expense Depreciation Expense is increased $40, and the contra asset
Accumulated Depreciation—Equipment is increased $40.
Assets
Accumulated
Depreciation—Equipment
!$40
= =
Liabilities Stockholders’ Equity +
Depreciation Expense
!$40
Equation
Analysis
Helpful Hint All contra accounts
have increases, decreases, and
normal balances opposite to the
account to which they relate.
Illustration 4-9 Balance
sheet presentation of
accumulated depreciation
Alternative Terminology Book
value is also referred to as
carrying value.
Equipment $ 5,000
Less: Accumulated depreciation—equipment 40
$4,960
Illustration 4-8
Adjustment for depreciation
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and customer deposits for future service may result in unearned revenues. Airlines
such as United, American, and Delta, for instance, treat receipts from the sale of tickets as unearned revenue until the flight service is provided.
Unearned revenues are the opposite of prepaid expenses. Indeed, unearned
revenue on the books of one company is likely to be a prepaid expense on the books
of the company that has made the advance payment. For example, if identical
accounting periods are assumed, a landlord will have unearned rent revenue
when a tenant has prepaid rent.
When a company receives payment for services to be provided in a future accounting period, it increases (credits) an unearned revenue (a liability) account to
recognize the liability that exists. The company subsequently earns revenues by providing service. During the accounting period it is not practical to make daily entries
as the company earns the revenue. Instead, we delay recognition of earned revenue
until the adjustment process. Then the company makes an adjusting entry to record
the revenue earned during the period and to show the liability that remains at the
end of the accounting period. Typically, prior to adjustment, liabilities are overstated
and revenues are understated. Therefore, as shown in Illustration 4-11, the adjusting entry for unearned revenues results in a decrease (a debit) to a liability account and an increase (a credit) to a revenue account.
Sierra Corporation received $1,200 on October 2 from R. Knox for guide services for multi-day trips expected to be completed by December 31. Sierra credited
the payment to Unearned Service Revenue, and this liability account shows a balance of $1,200 in the October 31 trial balance. From an evaluation of the service
Sierra performed for Knox during October, the company determines that it has
earned $400 in October. The liability (Unearned Service Revenue) is therefore decreased, and stockholders’ equity (Service Revenue) is increased.
As shown in Illustration 4-12 (page 174), the liability Unearned Service Revenue now shows a balance of $800. That amount represents the remaining guide
services expected to be performed in the future. At the same time, Service Revenue shows total revenue earned in October of $10,400. Without this adjustment,
revenues and net income are understated by $400 in the income statement.
The Basics of Adjusting Entries 173
Illustration 4-10
Accounting for prepaid
expenses
ACCOUNTING FOR PREPAID EXPENSES
Reason for Accounts Before Adjusting
Examples Adjustment Adjustment Entry
Insurance, supplies, Prepaid expenses Assets Dr. Expenses
advertising, rent, recorded in asset overstated. Cr. Assets
depreciation accounts have Expenses
been used. understated.
Illustration 4-11
Adjusting entries for
unearned revenues
Unearned Revenues
| Liability | Revenue | |
| Credit Adjusting Entry (+) |
Debit Adjusting Entry (–) |
Unadjusted Balance |
Some service has been
provided; some revenue
is recorded
Cash is received in advance;
liability is recorded
Oct. 2
Oct. 31
Unearned Revenues
Thank you
in advance for
your work
I will finish
by Dec. 31
$1,200
c04AccrualAccountingConcepts.qxd 8/4/10 12:09 PM Page 173
174 chapter 4 Accrual Accounting Concepts
Moreover, liabilities are overstated and stockholders’ equity is understated
| by $400 on the October 31 balance sheet. | Illustration 4-12 Service revenue accounts after |
Debit–Credit
Analysis
Journal
Entry
Posting
Basic
Analysis
| Oct. 31 Adj. 400 | Oct. 2 1,200 |
| Oct.31 Bal. 800 |
| Oct. 3 10,000 31 Adj. 400 |
| Oct. 31 Bal. 10,400 |
Unearned Service Revenue Service Revenue
Debits decrease liabilities: debit Unearned Service Revenue $400.
Credits increase revenues: credit Service Revenue $400.
| Oct. 31 | Unearned Service Revenue Service Revenue (To record revenue earned) |
400 | 400 |
The liability Unearned Service Revenue is decreased $400, and the revenue
Service Revenue is increased $400.
Assets
Unearned
Service Revenue
= + Liabilities Stockholders’ Equity
Service Revenue
Equation
Analysis
!$400 #$400
adjustment
Illustration 4-13
Accounting for unearned
revenues
ACCOUNTING FOR UNEARNED REVENUES
Reason for Accounts Before Adjusting
Examples Adjustment Adjustment Entry
Rent, magazine Unearned revenues Liabilities Dr. Liabilities
subscriptions, recorded in liability overstated. Cr. Revenues
customer deposits accounts have been Revenues
for future service earned. understated.
Suppose that Robert Jones purchases a $100 gift card at Best Buy on December 24,
2011, and gives it to his wife, Mary Jones, on December 25, 2011. On January 3,
2012, Mary uses the card to purchase $100 worth of CDs. When do you think
Best Buy should recognize revenue and why? (See page 223.)
Turning Gift Cards into Revenue
Those of you who are marketing majors (and even most of you who are not)
know that gift cards are among the hottest marketing tools in merchandising today. Customers purchase gift cards and give them to someone for later use. In a recent year,
gift-card sales topped $95 billion.
Although these programs are popular with marketing executives, they create accounting questions. Should revenue be recorded at the time the gift card is sold, or
when it is exercised? How should expired gift cards be accounted for? In its 2009 balance sheet, Best Buy reported unearned revenue related to gift cards of $479 million.
Source: Robert Berner, “Gift Cards: No Gift to Investors,” Business Week (March 14, 2005), p. 86.
Accounting Across the Organization
?
Illustration 4-13 summarizes the accounting for unearned revenues.
c04AccrualAccountingConcepts.qxd 8/3/10 1:50 PM Page 174
ADJUSTING ENTRIES FOR ACCRUALS
The second category of adjusting entries is accruals. Prior to an accrual adjustment, the revenue account (and the related asset account) or the expense account
(and the related liability account) are understated. Thus, the adjusting entry for
accruals will increase both a balance sheet and an income statement account.
Accrued Revenues
Revenues earned but not yet recorded at the statement date are accrued revenues.
Accrued revenues may accumulate (accrue) with the passing of time, as in the
case of interest revenue. These are unrecorded because the earning of interest
does not involve daily transactions. Companies do not record interest revenue
on a daily basis because it is often impractical to do so. Accrued revenues also
may result from services that have been performed but not yet billed nor collected, as in the case of commissions and fees. These may be unrecorded because only a portion of the total service has been provided and the clients won’t
be billed until the service has been completed.
An adjusting entry records the receivable that exists at the balance sheet date
and the revenue earned during the period. Prior to adjustment, both assets and
revenues are understated. As shown in Illustration 4-14 (page 176), an adjusting entry for accrued revenues results in an increase (a debit) to an asset
account and an increase (a credit) to a revenue account.
The Basics of Adjusting Entries 175
Action Plan
• Make adjusting entries at the
end of the period for revenues
earned and expenses incurred
in the period.
• Don’t forget to make adjusting
entries for deferrals. Failure to
adjust for deferrals leads to
overstatement of the asset or
liability and understatement of
the related expense or revenue.
| The ledger of Hammond, Inc., on March 31, 2012, includes these se ADJUSTING ENTRIES |
Do it! |
lected accounts before adjusting entries are prepared.
Debit Credit
| Prepaid Insurance Supplies |
$ 3,600 2,800 |
| Equipment Accumulated Depreciation—Equipment Unearned Service Revenue An analysis of the accounts shows the following. |
25,000 |
1. Insurance expires at the rate of $100 per month.
2. Supplies on hand total $800.
3. The equipment depreciates $200 a month.
4. One-half of the unearned service revenue was earned in March.
Prepare the adjusting entries for the month of March.
Solution
1. Insurance Expense 100
Prepaid Insurance 100
(To record insurance expired)
2. Supplies Expense 2,000
Supplies 2,000
(To record supplies used)
3. Depreciation Expense 200
Accumulated Depreciation—Equipment 200
(To record monthly depreciation)
4. Unearned Service Revenue 4,600
Service Revenue 4,600
(To record revenue earned)
FOR DEFERRALS
before you go on…
5
Prepare adjusting entries
for accruals.
Cash is received;
receivable is reduced
Revenue and receivable
are recorded for
unbilled services
Oct. 31
Nov. 10
Accrued Revenues
My fee
is $200
$
study objective
Related exercise material: BE4-4, BE4-5, BE4-6, BE4-7, and Do it! 4-1.
c04AccrualAccountingConcepts.qxd 8/3/10 1:50 PM Page 175
176 chapter 4 Accrual Accounting Concepts
In October, Sierra Corporation earned $200 for guide services that were not
billed to clients on or before October 31. Because these services are not billed,
they are not recorded. The accrual of unrecorded service revenue increases an
asset account, Accounts Receivable. It also increases stockholders’ equity by increasing a revenue account, Service Revenue, as shown in Illustration 4-15.
Accrued Revenues
| Asset | Revenue |
| Debit Adjusting Entry (+) |
Credit Adjusting Entry (+) |
Illustration 4-14 Adjusting
entries for accrued revenues
Helpful Hint For accruals, there
may have been no prior entry, and
the accounts requiring adjustment
may both have zero balances prior
to adjustment.
Ethics Note Computer Associates
International was accused of
backdating sales—that is, saying
that a sale that occurred at the
beginning of one quarter occurred
at the end of the previous quarter,
in order to achieve the previous
quarter’s sales targets.
Debit–Credit
Analysis
Journal
Entry
Posting
Basic
Analysis
| Oct. 31 Adj. 200 |
| Oct. 31 Bal. 200 |
Accounts Receivable
Debits increase assets: debit Accounts Receivable $200.
Credits increase revenues: credit Service Revenue $200.
| Oct. 31 | Accounts Receivable Service Revenue (To record revenue earned) |
200 | 200 |
The asset Accounts Receivable is increased $200, and the revenue Service
Revenue is increased $200.
Assets = + Liabilities Stockholders’ Equity
Service Revenue
#$200
Accounts
Receivable
#$200
Equation
Analysis
| Oct. 3 10,000 31 400 31 Adj. 200 |
| Oct. 31 Bal. 10,600 |
Service Revenue
The asset Accounts Receivable shows that clients owe Sierra $200 at the balance sheet date. The balance of $10,600 in Service Revenue represents the total
revenue Sierra earned during the month ($10,000 # $400 # $200). Without the
adjusting entry, assets and stockholders’ equity on the balance sheet and
revenues and net income on the income statement are understated.
On November 10, Sierra receives cash of $200 for the services performed in
October and makes the following entry.
Nov. 10 Cash 200
Accounts Receivable 200
(To record cash collected on account)
#200
!200
A = + L SE
Cash Flows
#200
Equation analyses
summarize the effects
of transactions on the three elements
of the accounting equation, as well as
the effect on cash flows.
Illustration 4-15
Adjustment for
accrued revenue
c04AccrualAccountingConcepts.qxd 8/3/10 1:50 PM Page 176
The company records the collection of the receivables by a debit (increase)
to Cash and a credit (decrease) to Accounts Receivable.
Illustration 4-16 summarizes the accounting for accrued revenues.
The Basics of Adjusting Entries 177
Accrued Expenses
Expenses incurred but not yet paid or recorded at the statement date are called
accrued expenses. Interest, taxes, and salaries are common examples of accrued
expenses.
Companies make adjustments for accrued expenses to record the obligations
that exist at the balance sheet date and to recognize the expenses that apply to
the current accounting period. Prior to adjustment, both liabilities and expenses
are understated. Therefore, an adjusting entry for accrued expenses results
in an increase (a debit) to an expense account and an increase (a credit)
to a liability account.
Let’s look in more detail at some specific types of accrued expenses, beginning with accrued interest.
ACCRUED INTEREST. Sierra Corporation signed a three-month note payable in
the amount of $5,000 on October 1. The note requires Sierra to pay interest at
an annual rate of 12%.
The amount of the interest recorded is determined by three factors: (1) the
face value of the note; (2) the interest rate, which is always expressed as an
annual rate; and (3) the length of time the note is outstanding. For Sierra, the
total interest due on the $5,000 note at its maturity date three months in the
future is $150 ($5,000 $ 12% $12 3 ), or $50 for one month. Illustration 4-18 shows
the formula for computing interest and its application to Sierra Corporation for
the month of October.
ACCOUNTING FOR ACCRUED REVENUES
Reason for Accounts Before Adjusting
Examples Adjustment Adjustment Entry
Interest, rent, Revenues have been Assets Dr. Assets
services performed earned but not yet understated. Cr. Revenues
but not collected received in cash Revenues
or recorded. understated.
Illustration 4-16
Accounting for accrued
revenues
Ethics Note A report released by
Fannie Mae’s board of directors
stated that improper adjusting
entries at the mortgage-finance
company resulted in delayed
recognition of expenses caused
by interest-rate changes. The
motivation for such accounting
apparently was the desire to hit
earnings estimates.
Illustration 4-17
Adjusting entries for
Accrued Expenses accrued expenses
| Expense | Liability |
| Credit Adjusting Entry (+) |
Debit Adjusting Entry (+) |
Illustration 4-18 Formula
Annual Time in for computing interest
Face Value ! Interest ! Terms of ” Interest
of Note Rate One Year
$5,000 $ 12% $ 12 1 % $50
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178 chapter 4 Accrual Accounting Concepts
As Illustration 4-19 shows, the accrual of interest at October 31 increases a
liability account, Interest Payable. It also decreases stockholders’ equity by increasing an expense account, Interest Expense.
Interest Expense shows the interest charges for the month of October. Interest Payable shows the amount of interest the company owes at the statement
date. Sierra will not pay the interest until the note comes due at the end of three
months. Companies use the Interest Payable account, instead of crediting Notes
Payable, to disclose the two different types of obligations—interest and principal—
in the accounts and statements. Without this adjusting entry, liabilities and
interest expense are understated, and net income and stockholders’ equity
are overstated.
Helpful Hint In computing
interest, we express the time
period as a fraction of a year.
Debit–Credit
Analysis
Journal
Entry
Posting
Basic
Analysis
Equation
Analysis
| Oct. 31 Adj. 50 |
| Oct. 31 Bal. 50 |
| Oct. 31 Adj. 50 |
| Oct. 31 Bal. 50 |
Interest Expense Interest Payable
Debits increase expenses: debit Interest Expense $50.
Credits increase liabilities: credit Interest Payable $50.
| Oct. 31 | Interest Expense Interest Payable (To record interest on notes payable) |
50 | 50 |
The expense Interest Expense is increased $50, and the liability Interest
Payable is increased $50.
Assets
Interest Payable
#$50
= + Liabilities Stockholders’ Equity
Interest Expense
!$50
Illustration 4-19
Adjustment for
accrued interest
Accrual accounting is often considered superior to cash accounting. Why, then,
were some people critical of China’s use of accrual accounting in this instance? (See
page 223.)
Cashing In on Accrual Accounting
The Chinese government, like most governments, uses cash accounting. It
was therefore interesting when it was recently reported that for about $38 billion of expenditures in a recent budget projection, the Chinese government decided to use accrual accounting versus cash accounting. It decided to expense the amount in the year
in which it was originally allocated rather than when the payments would be made. Why
did it do this? It enabled the government to keep its projected budget deficit below a
3% threshold. While it was able to keep its projected shortfall below 3%, China did suffer some criticism for its inconsistent accounting. Critics charge that this inconsistent
treatment reduces the transparency of China’s accounting information. That is, it is not
easy for outsiders to accurately evaluate what is really going on.
Source: Andrew Batson, “China Altered Budget Accounting to Reduce Deficit Figure,” Wall Street Journal
Online (March 15, 2010).
International Insight
?
c04AccrualAccountingConcepts.qxd 8/3/10 1:50 PM Page 178
ACCRUED SALARIES. Companies pay for some types of expenses, such as employee salaries and commissions, after the services have been performed. Sierra
paid salaries on October 26 for its employees’ first two weeks of work; the next
payment of salaries will not occur until November 9. As Illustration 4-20 shows,
three working days remain in October (October 29–31).
At October 31, the salaries for these three days represent an accrued expense
and a related liability to Sierra. The employees receive total salaries of $2,000
for a five-day work week, or $400 per day. Thus, accrued salaries at October 31
are $1,200 ($400 $ 3). This accrual increases a liability, Salaries Payable. It also
decreases stockholders’ equity by increasing an expense account, Salaries
Expense, as shown in Illustration 4-21.
After this adjustment, the balance in Salaries Expense of $5,200 (13 days $
$400) is the actual salary expense for October. The balance in Salaries Payable
The Basics of Adjusting Entries 179
Illustration 4-20 Calendar
showing Sierra Corporation’s
| October |
| S M Tu W Th F S 1 2 3 4 5 6 7 8 9 10 11 12 13 14 16 17 18 19 20 21 22 23 24 25 27 28 29 30 31 26 15 |
pay periods
Adjustment period
Start of
pay period
Payday Payday
| November |
| S M Tu W Th F S 1 2 3 4 5 6 7 8 10 11 13 14 15 16 17 18 19 20 21 22 24 25 26 27 28 23 29 30 12 9 |
Debit–Credit
Analysis
Journal
Entry
Posting
Basic
Analysis
Equation
Analysis
Oct. 26 4,000
31 Adj. 1,200
| Oct. 31 Bal. 5,200 |
| Oct. 31 Adj. 1,200 |
| Oct. 31 Bal. 1,200 |
Salaries Expense Salaries Payable
Debits increase expenses: debit Salaries Expense $1,200.
Credits increase liabilities: credit Salaries Payable $1,200.
| Oct. 31 | Salaries Expense Salaries Payable (To record accrued salaries) |
1,200 | 1,200 |
The expense Salaries Expense is increased $1,200, and the liability account
Salaries Payable is decreased $1,200.
Assets
Salaries Payable
#$1,200
= + Liabilities Stockholders’ Equity
Salaries Expense
!$1,200
Illustration 4-21
Adjustment for accrued
salaries
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180 chapter 4 Accrual Accounting Concepts
of $1,200 is the amount of the liability for salaries Sierra owes as of October 31.
Without the $1,200 adjustment for salaries, Sierra’s expenses are understated $1,200 and its liabilities are understated $1,200.
Sierra Corporation pays salaries every two weeks. Consequently, the next payday is November 9, when the company will again pay total salaries of $4,000. The
payment consists of $1,200 of salaries payable at October 31 plus $2,800 of salaries
expense for November (7 working days, as shown in the November calendar $
$400). Therefore, Sierra makes the following entry on November 9.
Nov. 9 Salaries Payable 1,200
Salaries Expense 2,800
Cash 4,000
(To record November 9 payroll)
This entry eliminates the liability for Salaries Payable that Sierra recorded in
the October 31 adjusting entry, and it records the proper amount of Salaries
Expense for the period between November 1 and November 9.
Illustration 4-22 summarizes the accounting for accrued expenses.
Illustration 4-22
Accounting for accrued
expenses
ACCOUNTING FOR ACCRUED EXPENSES
Reason for Accounts Before Adjusting
Examples Adjustment Adjustment Entry
Interest, rent, Expenses have been Expenses understated. Dr. Expenses
| salaries | incurred but not yet paid in cash or recorded. |
| ADJUSTING ENTRIES | Do it! | Micro Computer Services Inc. began operations on August 1, 2012. At |
FOR ACCRUALS
before you go on…
the end of August 2012, management attempted to prepare monthly financial statements.
The following information relates to August.
1. At August 31, the company owed its employees $800 in salaries that will be paid on
September 1.
2. On August 1, the company borrowed $30,000 from a local bank on a 15-year mortgage. The annual interest rate is 10%.
3. Revenue earned but unrecorded for August totaled $1,100.
Prepare the adjusting entries needed at August 31, 2012.
Solution
Action Plan
• Make adjusting entries at the
end of the period for revenues
earned and expenses incurred
in the period.
• Don’t forget to make adjusting
entries for accruals. Adjusting
entries for accruals will increase
both a balance sheet and an
income statement account.
1. Salaries Expense 800
Salaries Payable 800
(To record accrued salaries)
2. Interest Expense 250
Interest Payable 250
(To record accrued interest:
$30,000 $ 10% $ % $250)
3. Accounts Receivable 1,100
Service Revenue 1,100
(To record revenue earned)
1
12
Related exercise material: BE4-8, 4-2, E4-8, E4-9, E4-10, Do it! and E4-11.
c04AccrualAccountingConcepts.qxd 8/3/10 1:50 PM Page 180
SUMMARY OF BASIC RELATIONSHIPS
Illustration 4-23 summarizes the four basic types of adjusting entries. Take some
time to study and analyze the adjusting entries. Be sure to note that each adjusting entry affects one balance sheet account and one income statement
account.
Illustrations 4-24 and 4-25 (page 182) show the journalizing and posting of
adjusting entries for Sierra Corporation on October 31. When reviewing the general ledger in Illustration 4-25, note that for learning purposes, we have highlighted the adjustments in color.
The Basics of Adjusting Entries 181
Type of Adjustment Accounts Before Adjustment Adjusting Entry
Prepaid expenses Assets overstated Dr. Expenses
Expenses understated Cr. Assets
Unearned revenues Liabilities overstated Dr. Liabilities
Revenues understated Cr. Revenues
Accrued revenues Assets understated Dr. Assets
Revenues understated Cr. Revenues
Accrued expenses Expenses understated Dr. Expenses
Liabilities understated Cr. Liabilities
Illustration 4-23
Summary of adjusting
entries
Illustration 4-24 General
journal showing adjusting
entries
GENERAL JOURNAL
| Date | Account Titles and Explanation | Debit | Credit |
| 2010 Oct. 31 31 31 31 31 31 31 |
Adjusting Entries Supplies Expense Supplies (To record supplies used) Insurance Expense Prepaid Insurance (To record insurance expired) Depreciation Expense Accumulated Depreciation—Equipment (To record monthly depreciation) Unearned Service Revenue Service Revenue (To record revenue earned) Accounts Receivable Service Revenue (To record revenue earned) Interest Expense Interest Payable (To record interest on notes payable) Salaries Expense Salaries Payable (To record accrued salaries) |
1,500 50 40 400 200 50 1,200 |
1,500 50 40 400 200 50 1,200 |
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182 chapter 4 Accrual Accounting Concepts
Illustration 4-25 General
ledger after adjustments GENERAL LEDGER
Cash
| Oct. 1 10,000 1 5,000 2 1,200 3 10,000 |
Oct. 2 5,000 3 900 4 600 20 500 26 4,000 |
| Oct. 31 Bal. 15,200 |
Accounts Receivable
| Oct. 31 200 |
| Oct. 31 Bal. 200 |
Supplies
| Oct. 5 2,500 | Oct. 31 1,500 |
| Oct. 31 Bal. 1,000 |
Prepaid Insurance
| Oct. 4 600 | Oct. 31 50 |
| Oct. 31 Bal. 550 |
Equipment
| Oct. 2 5,000 |
| Oct. 31 Bal. 5,000 |
Accumulated Depreciation—
Equipment
| Oct. 31 40 |
| Oct. 31 Bal. 40 |
Notes Payable
| Oct. 1 5,000 |
Oct. 31 Bal. 5,000
Accounts Payable
| Oct. 5 2,500 |
| Oct. 31 Bal. 2,500 |
Interest Payable
| Oct. 31 50 |
| Oct. 31 Bal. 50 |
Unearned Service Revenue
| Oct. 31 400 | Oct. 2 1,200 |
Oct. 31 Bal. 800
Salaries Payable
| Oct. 31 1,200 |
Oct. 31 Bal. 1,200
Common Stock
| Oct. 1 10,000 |
Oct. 31 Bal. 10,000
Retained Earnings
| Oct. 31 Bal. 0 |
Dividends
| Oct. 20 500 |
| Oct. 31 Bal. 500 |
Service Revenue
| Oct. 3 10,000 31 400 31 200 |
| Oct. 31 Bal. 10,600 |
Salaries Expense
Oct. 26 4,000
31 1,200
| Oct. 31 Bal. 5,200 |
Supplies Expense
| Oct. 31 1,500 |
| Oct. 31 Bal. 1,500 |
Rent Expense
| Oct. 3 900 |
| Oct. 31 Bal. 900 |
Insurance Expense
| Oct. 31 50 |
Oct. 31 Bal. 50
Interest Expense
| Oct. 31 50 |
Oct. 31 Bal. 50
Depreciation Expense
| Oct. 31 40 |
| Oct. 31 Bal. 40 |
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The Adjusted Trial Balance and
Financial Statements
After a company has journalized and posted all adjusting entries, it prepares
another trial balance from the ledger accounts. This trial balance is called an
adjusted trial balance. It shows the balances of all accounts, including those
adjusted, at the end of the accounting period. The purpose of an adjusted trial
balance is to prove the equality of the total debit balances and the total credit
balances in the ledger after all adjustments. Because the accounts contain all
data needed for financial statements, the adjusted trial balance is the primary
basis for the preparation of financial statements.
PREPARING THE ADJUSTED TRIAL BALANCE
Illustration 4-26 presents the adjusted trial balance for Sierra Corporation prepared from the ledger accounts in Illustration 4-25. The amounts affected by the
adjusting entries are highlighted in color.
The Adjusted Trial Balance and Financial Statements 183
6
Describe the nature and
purpose of the adjusted
trial balance.
| SIERRA CORPORATION Adjusted Trial Balance |
October 31, 2012
Dr. Cr.
Cash $ 15,200
Accounts Receivable 200
Supplies 1,000
Prepaid Insurance 550
Equipment 5,000
Accumulated Depreciation—Equipment $ 40
Notes Payable 5,000
Accounts Payable 2,500
Interest Payable 50
Unearned Service Revenue 800
Salaries Payable 1,200
Common Stock 10,000
Retained Earnings 0
Dividends 500
Service Revenue 10,600
Salaries Expense 5,200
Supplies Expense 1,500
Rent Expense 900
Insurance Expense 50
Interest Expense 50
Depreciation Expense 40
$30,190 $30,190
Illustration 4-26
Adjusted trial balance
study objective
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184 chapter 4 Accrual Accounting Concepts
PREPARING FINANCIAL STATEMENTS
Companies can prepare financial statements directly from an adjusted trial
balance. Illustrations 4-27 and 4-28 present the interrelationships of data in the
adjusted trial balance of Sierra Corporation. As Illustration 4-27 shows, companies prepare the income statement from the revenue and expense accounts. Similarly, they derive the retained earnings statement from the retained earnings account, dividends account, and the net income (or net loss) shown in the income
statement. As Illustration 4-28 shows, companies then prepare the balance sheet
from the asset, liability, and stockholders’ equity accounts. They obtain the
amount reported for retained earnings on the balance sheet from the ending balance in the retained earnings statement.
Illustration 4-27
Preparation of the income
statement and retained
earnings statement from
the adjusted trial balance
| SIERRA CORPORATION |
Adjusted Trial Balance
October 31, 2012
Cash
Accounts Receivable
Supplies
Prepaid Insurance
Equipment
Accumulated Depreciation—
Equipment
Notes Payable
Accounts Payable
Interest Payable
Unearned Service Revenue
Salaries Payable
Common Stock
$15,200
200
1,000
550
5,000
500
5,200
1,500
900
50
50
40
$ 40
5,000
2,500
50
800
1,200
10,000
0
10,600
$30,190 $30,190
Account Debit Credit
SIERRA CORPORATION
Income Statement
For the Month Ended October 31, 2012
Revenues
Service revenue
Expenses
Salaries expense
Supplies expense
Rent expense
Insurance expense
Interest expense
Depreciation expense
Total expenses
Net income
$5,200
1,500
900
50
50
40
$10,600
7,740
$ 2,860
SIERRA CORPORATION
Retained Earnings Statement
For the Month Ended October 31, 2012
Retained earnings, October 1
Add: Net income
Less: Dividends
Retained earnings, October 31
$ 0
2,860
2,860
500
$ 2,360
Service Revenue
Salaries Expense
Supplies Expense
Rent Expense
Insurance Expense
Interest Expense
Depreciation Expense
Retained Earnings
Dividends
To balance sheet
c04AccrualAccountingConcepts.qxd 8/3/10 1:50 PM Page 184
The Adjusted Trial Balance and Financial Statements 185
Illustration 4-28
Preparation of the balance
sheet from the adjusted
trial balance
SIERRA CORPORATION
Adjusted Trial Balance
October 31, 2012
Cash
Accounts Receivable
Supplies
Prepaid Insurance
Equipment
Accumulated Depreciation—
Equipment
Notes Payable
Accounts Payable
Interest Payable
Unearned Service Revenue
Salaries Payable
Common Stock
Retained Earnings
Dividends
Service Revenue
Salaries Expense
Supplies Expense
Rent Expense
Insurance Expense
Interest Expense
Depreciation Expense
$15,200
200
1,000
550
5,000
500
5,200
1,500
900
50
50
40
$ 40
5,000
2,500
50
800
1,200
10,000
0
10,600
$30,190 $30,190
Account Debit Credit
| SIERRA CORPORATION Balance Sheet October 31, 2012 Cash Accounts receivable Supplies Prepaid insurance Equipment Less: Accumulated depreciation—equipment Total assets $5,000 40 Assets Liabilities Notes payable Accounts payable Salaries payable Unearned service revenue Interest payable Total liabilities Stockholders’ equity Common stock Retained earnings Total stockholders’ equity Total liabilities and stockholders’ equity $15,200 200 1,000 550 4,960 $21,910 Liabilities and Stockholders’ Equity $ 9,550 12,360 $21,910 $ 5,000 2,500 1,200 800 50 10,000 2,360 Balance at Oct. 31 from Retained Earnings Statement in Illustration 4-27 |
| Skolnick Co. was organized on April 1, 2012. The company prepares TRIAL BALANCE |
Do it! |
quarterly financial statements. The adjusted trial balance amounts at June 30 are shown
below:
Debits
Cash $ 6,700
Accounts Receivable 600
Prepaid Rent 900
Supplies 1,000
Equipment 15,000
Dividends 600
Salaries and Wages Expense 9,400
Rent Expense 1,500
Depreciation Expense 850
Supplies Expense 200
Utilities Expense 510
Interest Expense 50
Total debits $37,310
before you go on…
Credits
Accumulated Depreciation—Equipment $ 850
Notes Payable 5,000
Accounts Payable 1,510
Salaries and Wages Payable 400
Interest Payable 50
Unearned Rent Revenue 500
Common Stock 14,000
Service Revenue 14,200
Rent Revenue 800
Total credits $37,310
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186 chapter 4 Accrual Accounting Concepts
(a) Determine the net income for the quarter April 1 to June 30.
(b) Determine the total assets and total liabilities at June 30, 2012 for Skolnick Co.
(c) Determine the amount that appears for Retained Earnings.
Solution
Action Plan
• In an adjusted trial balance, all
asset, liability, revenue, and
expense accounts are properly
stated.
• To determine the ending
balance in Retained Earnings,
add net income and subtract
dividends.
(a) The net income is determined by adding revenues and subtracting expenses. The net
income is computed as follows.
Revenues
| Service revenue Rent revenue |
$14,200 800 |
| Total revenues | $15,000 |
| Expenses | |
| Salaries and wages expense $ 9,400 | |
| Rent expense | 1,500 |
| Depreciation expense | 850 |
| Utilities expense | 510 |
| Supplies expense | 200 |
| Interest expense | 50 |
| Total expenses Net income |
12,510 $ 2,490 |
| (b) Total assets and liabilities are computed as follows. | |
| Assets | Liabilities |
Cash $ 6,700 Notes payable $5,000
Accounts receivable 600 Accounts payable 1,510
Supplies 1,000 Unearned rent revenue 500
Prepaid rent 900 Salaries and wages
Equipment 15,000 payable 400
Less: Accumulated Interest payable 50
depreciation—
equipment 850 14,150
Total assets $23,350 Total liabilities $7,460
(c) Retained earnings, April 1 $ 0
Add: Net income 2,490
Less: Dividends 600
Retained earnings, June 30 $1,890
Closing the Books
In previous chapters, you learned that revenue and expense accounts and the dividends account are subdivisions of retained earnings, which is reported in the
stockholders’ equity section of the balance sheet. Because revenues, expenses, and
dividends relate to only a given accounting period, they are considered temporary accounts. In contrast, all balance sheet accounts are considered permanent
accounts because their balances are carried forward into future accounting
periods. Illustration 4-29 identifies the accounts in each category.
PREPARING CLOSING ENTRIES
At the end of the accounting period, companies transfer the temporary account
balances to the permanent stockholders’ equity account—Retained Earnings—
through the preparation of closing entries. Closing entries transfer net income
Alternative Terminology
Temporary accounts are sometimes
called nominal accounts, and
permanent accounts are sometimes
called real accounts.
7
Explain the purpose of
closing entries.
study objective
Related exercise material: BE4-9, BE4-10, BE4-11, BE4-12, 4-3, E4-12, E4-13, E4-15,
and E4-16.
Do it!
c04AccrualAccountingConcepts.qxd 8/3/10 1:50 PM Page 186
(or net loss) and dividends to Retained Earnings, so the balance in Retained
Earnings agrees with the retained earnings statement. For example, notice that
in the adjusted trial balance in Illustration 4-24 (page 183). Retained Earnings
has a balance of zero. Prior to the closing entries, the balance in Retained Earnings will be its beginning-of-the-period balance. (For Sierra, this is zero because
it is Sierra’s first month of operations.)
In addition to updating Retained Earnings to its correct ending balance, closing entries produce a zero balance in each temporary account. As a result,
these accounts are ready to accumulate data about revenues, expenses, and dividends that occur in the next accounting period. Permanent accounts are not
closed.
When companies prepare closing entries, they could close each income statement account directly to Retained Earnings. However, to do so would result in
excessive detail in the retained earnings account. Accordingly, companies close
the revenue and expense accounts to another temporary account, Income Summary, and they transfer only the resulting net income or net loss from this account to Retained Earnings. Illustration 4-30 depicts the closing process. While
it still takes the average large company seven days to close, some companies
such as Cisco employ technology that allows them to do a so-called “virtual close”
almost instantaneously any time during the year. Besides dramatically reducing
the cost of closing, the virtual close provides companies with accurate data for
decision making whenever they desire it.
Closing the Books 187
Temporary Permanent
Dividends
All expense accounts
All revenue accounts
Stockholders’ equity accounts
All liability accounts
All asset accounts
Illustration 4-29
Temporary versus
permanent accounts
Retained
Earnings
Expense
Accounts
Dividends
Income
Summary
Revenue
Accounts
Illustration 4-30 The
closing process
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188 chapter 4 Accrual Accounting Concepts
PREPARING A POST-CLOSING TRIAL BALANCE
After a company journalizes and posts all closing entries, it prepares another trial
balance, called a post-closing trial balance, from the ledger. A post-closing trial
balance is a list of all permanent accounts and their balances after closing entries
are journalized and posted. The purpose of this trial balance is to prove the
equality of the permanent account balances that the company carries forward into the next accounting period. Since all temporary accounts will have
zero balances, the post-closing trial balance will contain only permanent—
balance sheet—accounts.
Illustration 4-31 Closing
entries journalized GENERAL JOURNAL
| Date | Account Titles and Explanation | Debit | Credit |
| Closing Entries (1) Service Revenue Income Summary (To close revenue account) (2) Income Summary Salaries Expense Supplies Expense Rent Expense Insurance Expense Interest Expense Depreciation Expense (To close expense accounts) (3) Income Summary Retained Earnings (To close net income to retained earnings) (4) Retained Earnings Dividends (To close dividends to retained earnings) |
2012 Oct. 31 31 31 31 |
10,600 7,740 2,860 500 |
10,600 5,200 1,500 900 50 50 40 2,860 500 |
Illustration 4-31 shows the closing entries for Sierra Corporation. Illustration 4-32 diagrams the posting process for Sierra Corporation’s closing entries.
Helpful Hint Income Summary is
a very descriptive title: Companies
close total revenues to Income
Summary and total expenses to
Income Summary. The balance in
the Income Summary is a net
income or net loss.
c04AccrualAccountingConcepts.qxd 8/3/10 1:50 PM Page 188
| 4,000 1,200 |
5,200 (2) |
| 5,200 | 5,200 |
Salaries
Expense
| 900 | (2) 900 |
Rent
Expense
| 50 | (2) 50 |
Insurance
Expense
| 40 | (2) 40 |
Depreciation
Expense
| 50 | (2) 50 |
Interest
Expense
| 1,500 | (2) 1,500 |
Supplies
Expense
| 500 (4) |
–0– 2,860 (3) |
| Bal. 2,360 |
| 10,600 (1) |
10,000 400 200 |
| 10,600 | 10,600 |
Service
Revenue
| 500 | (4) 500 |
Dividends
| 7,740 2,860 (2) (3) |
10,600 (1) |
| 10,600 | 10,600 |
Income
Summary
2 2
1
3
4
Retained
Earnings
Illustration 4-32 Posting
of closing entries
| After making entries to close its revenue and expense accounts to Income CLOSING ENTRIES |
Do it! |
Summary, Hancock Company has the following balances.
| Dividends Retained Earnings Income Summary |
$15,000 42,000 18,000 (credit balance) |
Prepare the closing entries at December 31 that affect the stockholders’ equity accounts.
Solution
before you go on…
Dec. 31 Income Summary 18,000
Retained Earnings 18,000
(To close net income to retained
earnings)
31 Retained Earnings 15,000
Dividends 15,000
(To close dividends to retained
earnings)
Action Plan
• Close Income Summary to
Retained Earnings.
• Close Dividends to Retained
Earnings.
189
Related exercise material: BE4-13, BE4-14, 4-4, E4-14, Do it! and E4-18.
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190 chapter 4 Accrual Accounting Concepts
SUMMARY OF THE ACCOUNTING CYCLE
Illustration 4-33 shows the required steps in the accounting cycle. You can see
that the cycle begins with the analysis of business transactions and ends with
the preparation of a post-closing trial balance. Companies perform the steps in
the cycle in sequence and repeat them in each accounting period.
Steps 1–3 may occur daily during the accounting period, as explained in
Chapter 3. Companies perform Steps 4–7 on a periodic basis, such as monthly,
quarterly, or annually. Steps 8 and 9, closing entries and a post-closing trial
balance, usually take place only at the end of a company’s annual accounting
period.
Quality of Earnings
“Did you make your numbers today?” is a question asked often in both large and
small businesses. Companies and employees are continually under pressure to
“make the numbers”—that is, to have earnings that are in line with expectations.
As a consequence it is not surprising that many companies practice earnings
management. Earnings management is the planned timing of revenues, expenses, gains, and losses to smooth out bumps in net income. The quality of
8
Describe the required steps
in the accounting cycle.
7
Prepare financial
statements:
Income statement
Retained earnings statement
Balance sheet
5
Journalize and post
adjusting entries:
Deferrals/Accruals
6
Prepare an adjusted
trial balance
4
Prepare a
trial balance
3
Post to
ledger accounts
2
Journalize the
transactions
1
Analyze business
transactions
9
Prepare a post-closing
trial balance
8
Journalize and post
closing entries
Illustration 4-33
Required steps in the
accounting cycle
Helpful Hint Some companies
prefer to reverse certain adjusting
entries at the beginning of a new
accounting period. The company
makes a reversing entry at the
beginning of the next accounting
period; this entry is the exact
opposite of the adjusting entry
made in the previous period.
study objective
c04AccrualAccountingConcepts.qxd 8/3/10 1:50 PM Page 190
earnings is greatly affected when a company manages earnings up or down to
meet some targeted earnings number. A company that has a high quality of
earnings provides full and transparent information that will not confuse or mislead users of the financial statements. A company with questionable quality of
earnings may mislead investors and creditors, who believe they are relying on
relevant and reliable information. As a consequence, investors and creditors lose
confidence in financial reporting, and it becomes difficult for our capital markets to work efficiently.
Companies manage earnings in a variety of ways. One way is through the
use of one-time items to prop up earnings numbers. For example, ConAgra
Foods recorded a nonrecurring gain from the sale of Pilgrim’s Pride stock for
$186 million to help meet an earnings projection for the quarter.
Another way is to inflate revenue numbers in the short-run to the detriment of the long-run. For example, Bristol-Myers Squibb provided sales incentives to its wholesalers to encourage them to buy products at the end of the quarter (often referred to as channel-stuffing). As a result Bristol-Myers was able to
meet its sales projections. The problem was that the wholesalers could not sell
that amount of merchandise and ended up returning it to Bristol-Myers. The result was that Bristol-Myers had to restate its income numbers.
Companies also manage earnings through improper adjusting entries. Regulators investigated Xerox for accusations that it was booking too much revenue
up-front on multi-year contract sales. Financial executives at Office Max resigned
amid accusations that the company was recognizing rebates from its vendors
too early and therefore overstating revenue. Finally, WorldCom’s abuse of adjusting entries to meet its net income targets is unsurpassed: It used adjusting entries to increase net income by reclassifying liabilities as revenue and reclassifying expenses as assets. Investigations of the company’s books after it went
bankrupt revealed adjusting entries of more than a billion dollars that had no
supporting documentation.
The good news is that, as a result of investor pressure as well as the SarbanesOxley Act, many companies are trying to improve the quality of their financial
reporting. For example, hotel operator Marriott is now providing detailed information on the write-offs it has on loan guarantees it gives hotels. General Electric
has decided to provide more detail on its revenues and operating profits for
individual businesses it owns. IBM is attempting to provide a better breakdown
of its earnings. At the same time, regulators are taking a tough stand on the issue of quality of earnings. For example, one regulator noted that companies may
be required to restate their financials every single time that they account for any
transaction that had no legitimate purpose but was done solely for an accounting purpose, such as to smooth net income.
Quality of Earnings 191
In this chapter, you learned that adjusting entries are used to adjust numbers
that would otherwise be stated on a cash basis. Sierra Corporation’s income
statement (Illustration 4-27, page 184) shows net income of $2,860. The statement of cash flows reports a form of cash basis income referred to as “Net cash
provided by operating activities.” For example, Illustration 1-8 (page 15), which
shows a statement of cash flows, reports net cash provided by operating activities of $5,700 for Sierra. Net income and net cash provided by operating activities often differ. The difference for Sierra is $2,840 ($5,700 ! $2,860). The following summary shows the causes of this difference of $2,840.
KEEPING AN EYE
ON CASH
9
Understand the causes of
differences between net
income and cash provided
by operating activities.
study objective
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192 chapter 4 Accrual Accounting Concepts
| Computation of Net Cash Provided by Operating Activities |
Computation of Net Income |
(1) Cash received in advance from customer $ 1,200 $ 0
(2) Cash received from customers for services
provided 10,000 10,000
(3) Services provided for cash received
previously in (1) 0 400
(4) Services provided on account 0 200
(5) Payment of rent (900) (900)
(6) Purchase of insurance (600) 0
(7) Payment of employee salaries (4,000) (4,000)
(8) Use of supplies 0 (1,500)
(9) Use of insurance 0 (50)
(10) Depreciation 0 (40)
(11) Interest cost incurred, but not paid 0 (50)
(12) Salaries incurred, but not paid 0 (1,200)
$ 5,700 $ 2,860
For each item included in the computation of net cash provided by operating
activities, you should confirm that cash was either received or paid. For each
item in the income statement, the company should confirm that revenue was
earned (even when cash was not received) or that an expense was incurred (even
when cash was not paid).
Humana Corporation provides managed health care services to approximately 7
million people. Headquartered in Louisville, Kentucky, it has over 13,700 employees
in 15 states and Puerto Rico. A simplified version of Humana’s December 31, 2009,
adjusted trial balance is shown at the top of the next page.
Instructions
From the trial balance, prepare an income statement, retained earnings statement,
and classified balance sheet. Be sure to prepare them in that order, since each
statement depends on information determined in the preceding statement.
USING THE DECISION TOOLKIT
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Using the Decision Toolkit 193
HUMANA CORPORATION
Adjusted Trial Balance
December 31, 2009
(in millions)
Account Dr. Cr.
Cash $ 1,613
Short-Term Investments 6,190
Receivables 824
Other Current Assets 626
Property and Equipment, Net 679
Long-Term Investments 1,307
Goodwill 1,993
Other Long-Term Assets 921
Benefits Payable $ 3,222
Accounts Payable 1,308
Other Current Liabilities 730
Long-Term Debt 3,117
Common Stock 1,690
Dividends 0
Retained Earnings 3,046
Revenues 30,960
Medical Cost Expense 24,775
Selling, General, and Administrative Expense 4,227
Depreciation Expense 250
Interest Expense 106
Income Tax Expense 562
$44,073 $44,073
Solution
HUMANA CORPORATION
Income Statement
For the Year Ended December 31, 2009
(in millions)
Revenues $30,960
Medical cost expense $24,775
Selling, general, and administrative expense 4,227
Depreciation expense 250
Interest expense 106
Income tax expense 562 29,920
Net income $ 1,040
HUMANA CORPORATION
Retained Earnings Statement
For the Year Ended December 31, 2009
(in millions)
| Beginning retained earnings Add: Net income Less: Dividends |
$3,046 1,040 0 |
Ending retained earnings $4,086
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194 chapter 4 Accrual Accounting Concepts
HUMANA CORPORATION
Balance Sheet
December 31, 2009
(in millions)
Assets
Current assets
| Cash Short-term investments Receivables |
$ 1,613 6,190 824 |
| Other current assets | 626 |
| Total current assets Long-term investments Property and equipment, |
net of accumulated depreciation 679
Goodwill 1,993
Other long-term assets 921
Total assets $14,153
Liabilities and Stockholders’ Equity
Liabilities
Current liabilities
Accounts payable $1,308
Benefits payable 3,222
Other current liabilities 730
Total current liabilities $5,260
Long-term debt 3,117
Total liabilities 8,377
Stockholders’ equity
| Common stock | 1,690 |
| Retained earnings Total stockholders’ equity Total liabilities and stockholders’ equity |
4,086 |
Summary of Study Objectives
1 Explain the revenue recognition principle and the
expense recognition principle. The revenue recognition
principle dictates that companies recognize revenue
in the accounting period in which it is earned. The expense recognition principle dictates that companies
recognize expenses when expenses make their contribution to revenues.
2 Differentiate between the cash basis and the accrual
basis of accounting. Under the cash basis, companies
record events only in the periods in which the company receives or pays cash. Accrual-based accounting
means that companies record, in the periods in which
the events occur, events that change a company’s
financial statements even if cash has not been
exchanged.
3 Explain why adjusting entries are needed, and identify
the major types of adjusting entries. Companies make
adjusting entries at the end of an accounting period.
These entries ensure that companies record revenues
in the period in which they are earned and that companies recognize expenses in the period in which they
are incurred. The major types of adjusting entries are
prepaid expenses, unearned revenues, accrued revenues, and accrued expenses.
4 Prepare adjusting entries for deferrals. Deferrals are
either prepaid expenses or unearned revenues. Companies make adjusting entries for deferrals at the statement date to record the portion of the deferred item
that represents the expense incurred or the revenue
earned in the current accounting period.
5 Prepare adjusting entries for accruals. Accruals are
either accrued revenues or accrued expenses. Adjusting entries for accruals record revenues earned
and expenses incurred in the current accounting period that have not been recognized through daily
entries.
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6 Describe the nature and purpose of the adjusted trial
balance. An adjusted trial balance is a trial balance
that shows the balances of all accounts, including
those that have been adjusted, at the end of an accounting period. The purpose of an adjusted trial balance is to show the effects of all financial events that
have occurred during the accounting period.
7 Explain the purpose of closing entries. One purpose of
closing entries is to transfer net income or net loss for
the period to Retained Earnings. A second purpose is
to “zero-out” all temporary accounts (revenue accounts, expense accounts, and dividends) so that they
start each new period with a zero balance. To accomplish this, companies “close” all temporary accounts
at the end of an accounting period. They make separate entries to close revenues and expenses to Income
Summary; Income Summary to Retained Earnings;
and Dividends to Retained Earnings. Only temporary
accounts are closed.
8 Describe the required steps in the accounting cycle. The
required steps in the accounting cycle are: (a) analyze
business transactions, (b) journalize the transactions,
(c) post to ledger accounts, (d) prepare a trial balance,
(e) journalize and post adjusting entries, (f) prepare
an adjusted trial balance, (g) prepare financial statements, (h) journalize and post closing entries, and
(i) prepare a post-closing trial balance.
9 Understand the causes of differences between net income and net cash provided by operating activities. Net
income is based on accrual accounting, which relies on
the adjustment process. Net cash provided by operating
activities is determined by adding cash received from
operating the business and subtracting
cash expended during operations.
Appendix 4A: Adjusting Entries in an Automated World—Using a Worksheet 195
DECISION CHECKPOINTS TOOL TO USE FOR DECISION HOW TO EVALUATE RESULTS
At what point should the company
record revenue?
Need to understand the nature of
the company’s business
Record revenue when earned. A
service business earns revenue
when it performs a service.
Recognizing revenue too early
overstates current period revenue;
recognizing it too late understates
current period revenue.
INFO NEEDED FOR DECISION
At what point should the company
record expenses?
Need to understand the nature of
the company’s business
Expenses should “follow”
revenues—that is, match the effort
(expense) with the result
(revenue).
Recognizing expenses too early
overstates current period
expense; recognizing them too
late understates current period
expense.
DECISION TOOLKIT A SUMMARY
In the previous discussion, we used T accounts and trial balances to arrive at the
amounts used to prepare financial statements. Accountants frequently use a
device known as a worksheet to determine these amounts. A worksheet is a
multiple-column form that may be used in the adjustment process and in preparing financial statements. Accountants can prepare worksheets manually, but today
most use computer spreadsheets.
As its name suggests, the worksheet is a working tool for the accountant. A
worksheet is not a permanent accounting record; it is neither a journal nor
a part of the general ledger. The worksheet is merely a supplemental device used
to make it easier to prepare adjusting entries and the financial statements. Small
companies with relatively few accounts and adjustments may not need a worksheet. In large companies with numerous accounts and many adjustments, a
worksheet is almost indispensable.
appendix 4A
Adjusting Entries in an Automated
World—Using a Worksheet
Describe the purpose
and the basic form of a
worksheet.
study objective10
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196 chapter 4 Accrual Accounting Concepts
Illustration 4A-1 shows the basic form of a worksheet. Note the headings:
The worksheet starts with two columns for the Trial Balance. The next two
columns record all Adjustments. Next is the Adjusted Trial Balance. The last two
sets of columns correspond to the Income Statement and the Balance Sheet. All
items listed in the Adjusted Trial Balance columns are included in either the Income Statement or the Balance Sheet columns.
Sierra Corporation.xls
File Exit View Insert Format Tools Data Window Help
| B | C | D | E | F | G | H | I | J | K | A |
| Trial Balance | Adjustments | Trial Balance Adjusted | Statement Income | Balance Sheet | 4 | |||||
| Account Titles Cash |
1 | SIERRA CORPORATION Worksheet For the Month Ended October 31, 2012 |
||||||||
| Dr. | Cr. | Dr. | Cr. | Dr. | Cr. | Dr. | Cr. | Dr. 15,200 |
Cr. | |
| Supplies | 9 | 2,500 | 1,500 (a) |
1,000 | 1,000 | |||||
| Prepaid Insurance | 10 | 600 | 50 (b) |
550 | 550 | |||||
| Equipment | 11 | 5,000 | 5,000 | 5,000 | ||||||
| Notes Payable | 12 | 5,000 | 5,000 | 5,000 | ||||||
| Accounts Payable | 13 | 2,500 | 2,500 | 2,500 | ||||||
| Unearned Service Revenue | 14 | 1,200 | 400 (d) |
800 | 800 | |||||
| Common Stock | 15 | 10,000 | 10,000 | 10,000 | ||||||
| Retained Earnings | 16 | –0– | –0– | –0– | ||||||
| Dividends | 17 | 500 | 500 | 500 | ||||||
| Service Revenue | 18 | 10,000 | 400 (d) |
10,600 | 10,600 | |||||
| Salaries Expense | 20 | 4,000 | 1,200 (g) |
5,200 | 5,200 | |||||
| Rent Expense | 21 | 900 | 900 | 900 | ||||||
| Totals | 22 | 28,700 | 28,700 | |||||||
| Supplies Expense | 24 | 1,500 (a) |
1,500 | 1,500 | ||||||
| Insurance Expense | 25 | 50 (b) |
50 | 50 | ||||||
| Accum. Depreciation— | 26 | |||||||||
| Equipment | 27 | 40 (c) |
40 | 40 | ||||||
| Depreciation Expense | 28 | 40 (c) |
40 | 40 | ||||||
| Interest Expense | 29 | 50 (f) |
50 | 50 | ||||||
| Accounts Receivable | 30 | 200 (e) |
200 | 200 | ||||||
| Interest Payable | 31 | 50 (f) |
50 | 50 | ||||||
| Salaries Payable | 32 | 1,200 (g) |
1,200 | 1,200 | ||||||
| Totals | 33 | 3,440 | 3,440 | 30,190 | 30,190 | 7,740 | 10,600 | 22,450 | 19,590 | |
| Net Income | 35 | 2,860 | 2,860 | |||||||
| Totals | 36 | 10,600 | 10,600 | 22,450 | 22,450 | |||||
| 2 | ||||||||||
| 3 | ||||||||||
| 5 | ||||||||||
| 6 | ||||||||||
| 7 | ||||||||||
| 8 | 15,200 | 15,200 | ||||||||
| 19 | 200 (e) |
|||||||||
| 23 | ||||||||||
| 34 |
1.
Prepare a
trial balance
on the
worksheet
2.
Enter
adjustment
data
3.
Enter
adjusted
balances
4.
Extend adjusted
balances to appropriate
statement columns
5.
Total the statement columns,
compute net income
(or net loss), and
complete worksheet
Illustration 4A-1 Form
and procedure for a
worksheet
Summary of Study Objective for Appendix 4A
10 Describe the purpose and the basic form of a worksheet. The worksheet is a device to make it easier to
prepare adjusting entries and the financial statements. Companies often prepare a worksheet on a
computer spreadsheet. The sets of columns of the
worksheet are, from left to right, the unadjusted trial
balance, adjustments, adjusted trial balance, income
statement, and balance sheet.
c04AccrualAccountingConcepts.qxd 8/3/10 1:50 PM Page 196
Comprehensive Do it! 197
Glossary
Accrual-basis accounting (p. 166) Accounting basis in
which companies record, in the periods in which the
events occur, transactions that change a company’s financial statements, even if cash was not exchanged.
Accrued expenses (p. 177) Expenses incurred but not
yet paid in cash or recorded.
Accrued revenues (p. 175) Revenues earned but not
yet received in cash or recorded.
Adjusted trial balance (p. 183) A list of accounts and
their balances after all adjustments have been made.
Adjusting entries (p. 167) Entries made at the end of
an accounting period to ensure that the revenue recognition and expense recognition principles are followed.
Book value (p. 172) The difference between the cost of a
depreciable asset and its related accumulated depreciation.
Cash-basis accounting (p. 166) Accounting basis in
which a company records revenue only when it receives
cash, and an expense only when it pays cash.
Closing entries (p. 186) Entries at the end of an accounting period to transfer the balances of temporary accounts to a permanent stockholders’ equity account, Retained Earnings.
Contra asset account (p. 171) An account that is offset against an asset account on the balance sheet.
Depreciation (p. 171) The process of allocating the
cost of an asset to expense over its useful life.
Earnings management (p. 190) The planned timing of
revenues, expenses, gains, and losses to smooth out
bumps in net income.
Expense recognition principle (matching principle)
(p. 165) The principle that dictates that companies
match efforts (expenses) with results (revenues).
Fiscal year (p. 164, in margin) An accounting period
that is one year long.
Income Summary (p. 187) A temporary account used
in closing revenue and expense accounts.
Periodicity assumption (p. 164) An assumption that
the economic life of a business can be divided into artificial time periods.
Permanent accounts (p. 186) Balance sheet accounts
whose balances are carried forward to the next accounting period.
Post-closing trial balance (p. 188) A list of permanent
accounts and their balances after a company has journalized and posted closing entries.
Prepaid expenses (prepayments) (p. 169) Assets that
result from the payment of expenses that benefit more
than one accounting period.
Quality of earnings (p. 191) Indicates the level of full
and transparent information that a company provides to
users of its financial statements.
Revenue recognition principle (p. 164) The principle
that companies recognize revenue in the accounting period in which it is earned.
Reversing entry (p. 190, in margin) An entry made at
the beginning of the next accounting period; the exact opposite of the adjusting entry made in the previous period.
Temporary accounts (p. 186) Revenue, expense, and
dividend accounts whose balances a company transfers
to Retained Earnings at the end of an accounting period.
Unearned revenues (p. 172) Cash received before a
company earns revenues and recorded as a liability until
earned.
Useful life (p. 171) The length of service of a productive asset.
Worksheet (p. 195) A multiple-column form that companies may use in the adjustment process and in preparing financial statements.
Comprehensive
Terry Thomas and a group of investors incorporate the Green Thumb Lawn Care
Corporation on April 1. At April 30, the trial balance shows the following balances for
selected accounts.
| Prepaid Insurance Equipment |
$ 3,600 28,000 |
| Notes Payable | 20,000 |
| Unearned Service Revenue | 4,200 |
| Service Revenue | 1,800 |
Analysis reveals the following additional data pertaining to these accounts.
1. Prepaid insurance is the cost of a 2-year insurance policy, effective April 1.
2. Depreciation on the equipment is $500 per month.
3. The note payable is dated April 1. It is a 6-month, 12% note.
Do it!
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198 chapter 4 Accrual Accounting Concepts
4. Seven customers paid for the company’s 6-month lawn service package of $600 beginning in April. These customers received the first month of services in April.
5. Lawn services performed for other customers but not billed at April 30 totaled $1,500.
Instructions
Prepare the adjusting entries for the month of April. Show computations.
Solution to Comprehensive
GENERAL JOURNAL
| Date | Account Titles and Explanation | Debit | Credit |
| Adjusting Entries Insurance Expense Prepaid Insurance (To record insurance expired: $3,600 ” 24 % $150 per month) Depreciation Expense Accumulated Depreciation—Equipment (To record monthly depreciation) Interest Expense Interest Payable (To accrue interest on notes payable: $20,000 $ 12% $ &11&2 % $200) Unearned Service Revenue Service Revenue (To record revenue earned: $600 ” 6 % $100; $100 per month $ 7 % $700) Accounts Receivable Service Revenue (To accrue revenue earned but not billed or collected) |
Apr. 30 30 30 30 30 |
150 500 200 700 1,500 |
150 500 200 700 1,500 |
Do it!
Action Plan
• Note that adjustments are being
made for one month.
• Make computations carefully.
• Select account titles carefully.
• Make sure debits are made first
and credits are indented.
• Check that debits equal credits
for each entry.
Self-Test Questions
Answers are on page 223.
1. What is the periodicity assumption?
(a) Companies should recognize revenue in the
accounting period in which it is earned.
(b) Companies should match expenses with revenues.
(c) The economic life of a business can be divided
into artificial time periods.
(d) The fiscal year should correspond with the
calendar year.
2. Which principle dictates that efforts (expenses) be
recorded with accomplishments (revenues)?
(a) Expense recognition principle.
(b) Cost principle.
(c) Periodicity principle.
(d) Revenue recognition principle.
3. Which one of these statements about the
accrual basis of accounting is false?
(a) Companies record events that change their financial statements in the period in which events
occur, even if cash was not exchanged.
(b) Companies recognize revenue in the period in
which it is earned.
(c) This basis is in accord with generally accepted
accounting principles.
(d) Companies record revenue only when they
receive cash, and record expense only when they
pay out cash.
4. Adjusting entries are made to ensure that:
(a) expenses are recognized in the period in which
they are incurred.
(SO 1)
(SO 1)
(SO 2)
(SO 3)
Self-Test, Brief Exercises, Exercises, Problem Set A, and many
more resources are available for practice in WileyPLUS
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Questions 199
(b) revenues are recorded in the period in which
they are earned.
(c) balance sheet and income statement accounts
have correct balances at the end of an accounting
period.
(d) All of the above.
5. Each of the following is a major type (or category)
of adjusting entry except:
| (a) prepaid expenses. (b) accrued revenues. |
(c) accrued expenses. (d) earned expenses. |
6. The trial balance shows Supplies $1,350 and Supplies Expense $0. If $600 of supplies are on hand at
the end of the period, the adjusting entry is:
(a) Supplies 600
Supplies Expense 600
(b) Supplies 750
Supplies Expense 750
(c) Supplies Expense 750
Supplies 750
(d) Supplies Expense 600
Supplies 600
7. Adjustments for unearned revenues:
(a) decrease liabilities and increase revenues.
(b) increase liabilities and increase revenues.
(c) increase assets and increase revenues.
(d) decrease revenues and decrease assets.
8. Adjustments for prepaid expenses:
(a) decrease assets and increase revenues.
(b) decrease expenses and increase assets.
(c) decrease assets and increase expenses.
(d) decrease revenues and increase assets.
9. Queenan Company computes depreciation on delivery
equipment at $1,000 for the month of June. The adjusting entry to record this depreciation is as follows:
(a) Depreciation Expense 1,000
Accumulated Depreciation—
Queenan Company 1,000
(b) Depreciation Expense 1,000
Equipment 1,000
(c) Depreciation Expense 1,000
Accumulated Depreciation—
Equipment 1,000
(d) Equipment Expense 1,000
Accumulated Depreciation—
Equipment 1,000
10. Adjustments for accrued revenues:
(a) increase assets and increase liabilities.
(b) increase assets and increase revenues.
(c) decrease assets and decrease revenues.
(d) decrease liabilities and increase revenues.
11. Colleen Mooney earned a salary of $400 for the last
week of September. She will be paid on October 1.
The adjusting entry for Colleen’s employer at September 30 is:
(a) No entry is required.
(b) Salaries and Wages Expense 400
Salaries and Wages Payable 400
(c) Salaries and Wages Expense 400
Cash 400
(d) Salaries and Wages Payable 400
Cash 400
12. Which statement is incorrect concerning the adjusted trial balance?
(a) An adjusted trial balance proves the equality of
the total debit balances and the total credit balances in the ledger after all adjustments are made.
(b) The adjusted trial balance provides the primary
basis for the preparation of financial statements.
(c) The adjusted trial balance does not list temporary accounts.
(d) The company prepares the adjusted trial balance after it has journalized and posted the
adjusting entries.
13. Which account will have a zero balance after a company has journalized and posted closing entries?
(a) Service Revenue.
(b) Supplies.
(c) Prepaid Insurance.
(d) Accumulated Depreciation.
14. Which types of accounts will appear in the postclosing trial balance?
(a) Permanent accounts.
(b) Temporary accounts.
(c) Expense accounts.
(d) None of the above.
15. All of the following are required steps in the accounting cycle except:
(a) journalizing and posting closing entries.
(b) preparing an adjusted trial balance.
(c) preparing a post-closing trial balance.
(d) reversing entries.
Go to the book’s companion website,
www.wiley.com/college/kimmel, to access
additional Self-Test Questions.
(SO 4, 5)
(SO 4)
(SO 4)
(SO 4)
(SO 4)
(SO 5)
(SO 5)
(SO 6)
(SO 7)
(SO 7)
(SO 8)
Note: All asterisked Questions relate to material in the appendix to the chapter.
Questions
1. (a) How does the periodicity assumption affect an
accountant’s analysis of accounting transactions?
(b) Explain the term fiscal year.
2. Identify and state two generally accepted accounting
principles that relate to adjusting the accounts.
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200 chapter 4 Accrual Accounting Concepts
types of accounts is debited and which is credited in
the adjusting entry: (a) asset, (b) liability, (c) revenue,
or (d) expense.
17. A company makes an accrued revenue adjusting entry for $780 and an accrued expense adjusting entry for $510. How much was net income understated prior to these entries? Explain.
18. On January 9 a company pays $6,200 for salaries, of
which $1,100 was reported as Salaries and Wages
Payable on December 31. Give the entry to record the
payment.
19. For each of the following items before adjustment,
indicate the type of adjusting entry—prepaid expense,
unearned revenue, accrued revenue, and accrued expense—that is needed to correct the misstatement. If
an item could result in more than one type of adjusting entry, indicate each of the types.
(a) Assets are understated.
(b) Liabilities are overstated.
(c) Liabilities are understated.
(d) Expenses are understated.
(e) Assets are overstated.
(f) Revenue is understated.
20. One-half of the adjusting entry is given below. Indicate the account title for the other half of the entry.
(a) Salaries and Wages Expense is debited.
(b) Depreciation Expense is debited.
(c) Interest Payable is credited.
(d) Supplies is credited.
(e) Accounts Receivable is debited.
(f) Unearned Service Revenue is debited.
21. “An adjusting entry may affect more than one balance sheet or income statement account.” Do you
agree? Why or why not?
22. Which balance sheet account provides evidence that Tootsie Roll records sales on an accrual
basis rather than a cash basis? Explain.
23. Why is it possible to prepare financial statements directly from an adjusted trial balance?
24.
(a) What information do accrual basis financial statements provide that cash basis statements do not?
(b) What information do cash basis financial statements provide that accrual basis statements do
not?
25. What is the relationship, if any, between the amount
shown in the adjusted trial balance column for an account and that account’s ledger balance?
26. Identify the account(s) debited and credited in each
of the four closing entries, assuming the company has
net income for the year.
27. Some companies employ technologies that allow them to do a so-called “virtual close.” This enables
them to close their books nearly instantaneously any
time during the year. What advantages does a “virtual
close” provide?
28. Describe the nature of the Income Summary account,
and identify the types of summary data that may be
posted to this account.
3. Don Wishne, a lawyer, accepts a legal engagement in March, performs the work in April, and
is paid in May. If Wishne’s law firm prepares monthly
financial statements, when should it recognize revenue from this engagement? Why?
4. In completing the engagement in question
3, Wishne pays no costs in March, $2,500 in April,
and $2,200 in May (incurred in April). How much expense should the firm deduct from revenues in the
month when it recognizes the revenue? Why?
5. “The cost principle of accounting requires adjusting
entries.” Do you agree? Explain.
6. Why may the financial information in an unadjusted
trial balance not be up-to-date and complete?
7. Distinguish between the two categories of adjusting
entries, and identify the types of adjustments applicable to each category.
8. What types of accounts does a company debit and
credit in a prepaid expense adjusting entry?
9. “Depreciation is a process of valuation that results in
the reporting of the fair value of the asset.” Do you
agree? Explain.
10. Explain the differences between depreciation expense
and accumulated depreciation.
11. Greenstreet Company purchased equipment for
$15,000. By the current balance sheet date, the company had depreciated $7,000. Indicate the balance
sheet presentation of the data.
12. What types of accounts are debited and credited in
an unearned revenue adjusting entry?
13. Data Technologies provides maintenance service for
computers and office equipment for companies
throughout the Northeast. The sales manager is
elated because she closed a $300,000 three-year maintenance contract on December 29, 2011, two days
before the company’s year-end. “Now we will hit this
year’s net income target for sure,” she crowed. The
customer is required to pay $100,000 on December 29
(the day the deal was closed). Two more payments of
$100,000 each are also required on December 29,
2012 and 2013. Discuss the effect that this event will
have on the company’s financial statements.
14. ValuMart, a large national retail chain, is nearing its
fiscal year-end. It appears that the company is not going to hit its revenue and net income targets. The
company’s marketing manager, Chris Ahrentzen, suggests running a promotion selling $50 gift cards for
$45. He believes that this would be very popular and
would enable the company to meet its targets for revenue and net income. What do you think of this idea?
15. A company fails to recognize revenue
earned but not yet received. Which of the following
types of accounts are involved in the adjusting entry:
(a) asset, (b) liability, (c) revenue, or (d) expense? For
the accounts selected, indicate whether they would
be debited or credited in the entry.
16. A company fails to recognize an expense incurred but not paid. Indicate which of the following
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Brief Exercises 201
32. Identify, in the sequence in which they are prepared,
the three trial balances that are required in the accounting cycle.
33. Explain the terms earnings management and
quality of earnings.
34. Give examples of how companies manage
earnings.
*35. What is the purpose of a worksheet?
*36. What is the basic form of a worksheet?
29. What items are disclosed on a post-closing trial balance, and what is its purpose?
30. Which of these accounts would not appear in the
post-closing trial balance? Interest Payable,
Equipment, Depreciation Expense, Dividends, Unearned Service Revenue, Accumulated Depreciation—
Equipment, and Service Revenue.
31. Indicate, in the sequence in which they are made, the
three required steps in the accounting cycle that
involve journalizing.
Brief Exercises
BE4-1 Transactions that affect earnings do not necessarily affect cash. Identify the effect, if any, that each of the following transactions would have upon cash and net income.
The first transaction has been completed as an example.
Net
| Cash !$100 |
Income $ 0 |
(a) Purchased $100 of supplies for cash. |
(b) Recorded an adjusting entry to record use of $20 of the above supplies.
(c) Made sales of $1,300, all on account.
(d) Received $800 from customers in payment of their accounts.
(e) Purchased equipment for cash, $2,500.
(f) Recorded depreciation of building for period used, $600.
BE4-2 The ledger of Hubbard Company includes the following accounts. Explain why
each account may require adjustment.
(a) Prepaid Insurance.
(b) Depreciation Expense.
(c) Unearned Service Revenue.
(d) Interest Payable.
BE4-3 Dicker Company accumulates the following adjustment data at December 31.
Indicate (1) the type of adjustment (prepaid expense, accrued revenue, and so on) and
(2) the status of the accounts before adjustment (overstated or understated).
(a) Supplies of $400 are on hand. Supplies account shows $1,600 balance.
(b) Service Revenue earned but unbilled total $700.
(c) Interest of $300 has accumulated on a note payable.
(d) Rent collected in advance totaling $1,100 has been earned.
BE4-4 Stagg Advertising Company’s trial balance at December 31 shows Supplies $8,800
and Supplies Expense $0. On December 31 there are $1,100 of supplies on hand. Prepare
the adjusting entry at December 31 and, using T accounts, enter the balances in the accounts, post the adjusting entry, and indicate the adjusted balance in each account.
BE4-5 At the end of its first year, the trial balance of Jules Company shows Equipment
$22,000 and zero balances in Accumulated Depreciation—Equipment and Depreciation
Expense. Depreciation for the year is estimated to be $2,750. Prepare the adjusting entry for depreciation at December 31, post the adjustments to T accounts, and indicate
the balance sheet presentation of the equipment at December 31.
BE4-6 On July 1, 2012, Ryhn Co. pays $12,400 to Craig Insurance Co. for a 2-year insurance contract. Both companies have fiscal years ending December 31. For Ryhn Co.,
journalize and post the entry on July 1 and the adjusting entry on December 31.
BE4-7 Using the data in BE4-6, journalize and post the entry on July 1 and the adjusting entry on December 31 for Craig Insurance Co. Craig uses the accounts Unearned
Service Revenue and Service Revenue.
BE4-8 The bookkeeper for Forseth Company asks you to prepare the following accrual
adjusting entries at December 31.
Identify impact of
transactions on cash and net
income.
(SO 2, 9), C
Indicate why adjusting
entries are needed.
(SO 3), C
Prepare adjusting entry
for supplies.
(SO 4), AP
Prepare adjusting entry
for depreciation.
(SO 4), AP
Prepare adjusting entry
for prepaid expense.
(SO 4), AP
Prepare adjusting entry
for unearned revenue.
(SO 4), AP
Prepare adjusting entries
for accruals.
(SO 5), AP
Identify the major types
of adjusting entries.
(SO 3), AN
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202 chapter 4 Accrual Accounting Concepts
(a) Interest on notes payable of $300 is accrued.
(b) Service revenue earned but unbilled totals $1,700.
(c) Salaries of $780 earned by employees have not been recorded.
Use these account titles: Service Revenue, Accounts Receivable, Interest Expense, Interest Payable, Salaries and Wages Expense, and Salaries and Wages Payable.
BE4-9 The trial balance of LaGrace Company includes the following balance sheet
accounts. Identify the accounts that might require adjustment. For each account that
requires adjustment, indicate (1) the type of adjusting entry (prepaid expenses, unearned
revenues, accrued revenues, and accrued expenses) and (2) the related account in the
adjusting entry.
| (a) Accounts Receivable. (b) Prepaid Insurance. (c) Equipment. (d) Accumulated Depreciation—Equipment. |
(e) Notes Payable. (f) Interest Payable. (g) Unearned Service Revenue. |
BE4-10 The adjusted trial balance of Hanlon Corporation at December 31, 2012, includes
the following accounts: Retained Earnings $17,200; Dividends $6,000; Service Revenue
$32,000; Salaries and Wages Expense $14,000; Insurance Expense $1,800; Rent Expense
$3,900; Supplies Expense $1,500; and Depreciation Expense $1,000. Prepare an income
statement for the year.
BE4-11 Partial adjusted trial balance data for Hanlon Corporation are presented in BE4-
10. The balance in Retained Earnings is the balance as of January 1. Prepare a retained
earnings statement for the year assuming net income is $10,400.
BE4-12 The following selected accounts appear in the adjusted trial balance for Cohen
Company. Indicate the financial statement on which each account would be reported.
| (a) Accumulated Depreciation. (b) Depreciation Expense. (c) Retained Earnings (beginning). (d) Dividends. |
(e) Service Revenue. (f) Supplies. (g) Accounts Payable. |
BE4-13 Using the data in BE4-12, identify the accounts that would be included in a
post-closing trial balance.
BE4-14 The income statement for the Timberline Golf Club Inc. for the month ended
July 31 shows Service Revenue $16,000; Salaries and Wages Expense $8,400; Maintenance
and Repairs Expense $2,500; and Income Tax Expense $1,000. The statement of retained
earnings shows an opening balance for Retained Earnings of $20,000 and Dividends $1,300.
(a) Prepare closing journal entries.
(b) What is the ending balance in Retained Earnings?
BE4-15 The required steps in the accounting cycle are listed in random order below.
List the steps in proper sequence.
(a) Prepare a post-closing trial balance.
(b) Prepare an adjusted trial balance.
(c) Analyze business transactions.
(d) Prepare a trial balance.
(e) Journalize the transactions.
(f) Journalize and post closing entries.
(g) Prepare financial statements.
(h) Journalize and post adjusting entries.
(i) Post to ledger accounts.
Prepare an income statement
from an adjusted trial
balance.
(SO 6), AP
Prepare a retained earnings
statement from an adjusted
trial balance.
(SO 6), AP
Identify financial statement
for selected accounts.
(SO 6), K
Identify post-closing trial
balance accounts.
(SO 7), K
Prepare and post closing
entries.
(SO 7), AP
Analyze accounts in an
adjusted trial balance.
(SO 6), AN
List required steps in the
accounting cycle sequence.
(SO 8), K
| 4-1 Do it! |
The ledger of Witzling, Inc. on March 31, 2012, includes the following |
| selected accounts before adjusting entries. | |
| Debit | Credit |
| Prepaid Insurance | 2,400 |
| Supplies | 2,500 |
| Equipment | 30,000 |
| Unearned Service Revenue | 10,000 |
Do it! Review
Prepare adjusting entries
for deferrals.
(SO 4), AP
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An analysis of the accounts shows the following:
1. Insurance expires at the rate of $300 per month.
2. Supplies on hand total $900.
3. The office equipment depreciates $200 per month.
4. 2/5 of the unearned service revenue was earned in March.
Prepare the adjusting entries for the month of March.
4-2 Tammy Krause is the new owner of Tammy’s Computer Services. At the
end of July 2012, her first month of ownership, Tammy is trying to prepare monthly financial statements. She has the following information for the month.
1. At July 31, Krause owed employees $1,100 in salaries that the company will pay in
August.
2. On July 1, Krause borrowed $20,000 from a local bank on a 10-year note. The annual interest rate is 9%.
3. Service revenue unrecorded in July totaled $1,600.
Prepare the adjusting entries needed at July 31, 2012.
4-3 Indicate in which financial statement each of the following adjusted trial
balance accounts would be presented.
| Service Revenue | Accounts Receivable |
| Notes Payable | Accumulated Depreciation |
| Common Stock | Utilities Expense |
| 4-4 After closing revenues and expense, Natraj Company shows the following Do it! |
|
| account balances. Dividends Retained Earnings Income Summary |
$22,000 70,000 36,000 (credit balance) |
Prepare the remaining closing entries at December 31.
Do it!
Do it!
Exercises 203
Prepare adjusting entries
for accruals.
(SO 5), AP
Prepare financial statements
from adjusted trial balance.
(SO 6), C
Prepare closing entries.
(SO 7), AP
Exercises
E4-1 The following independent situations require professional judgment for determining when to recognize revenue from the transactions.
(a) Southwest Airlines sells you an advance-purchase airline ticket in September for your
flight home at Christmas.
(b) Ultimate Electronics sells you a home theatre on a “no money down and full payment in three months” promotional deal.
(c) The Toronto Blue Jays sell season tickets online to games in the Skydome. Fans can
purchase the tickets at any time, although the season doesn’t officially begin until
April. The major league baseball season runs from April through October.
(d) You borrow money in August from RBC Financial Group. The loan and the interest
are repayable in full in November.
(e) In August, you order a sweater from Sears using its online catalog. The sweater arrives in September, and you charge it to your Sears credit card. You receive and pay
the Sears bill in October.
Instructions
Identify when revenue should be recognized in each of the above situations.
E4-2 These are the assumptions, principles, and constraints discussed in this and previous chapters.
1. Economic entity assumption. 6. Materiality constraint.
2. Expense recognition principle. 7. Full disclosure principle.
3. Monetary unit assumption. 8. Going concern assumption.
4. Periodicity assumption. 9. Revenue recognition principle.
5. Cost principle. 10. Cost constraint.
Identify point of revenue
recognition.
(SO 1), C
Identify accounting
assumptions, principles,
and constraints.
(SO 1), K
c04AccrualAccountingConcepts.qxd 8/3/10 1:50 PM Page 203
Instructions
Identify by number the accounting assumption, principle, or constraint that describes
each situation below. Do not use a number more than once.
_____ (a) Is the rationale for why plant assets are not reported at liquidation value. (Do
not use the cost principle.)
_____ (b) Indicates that personal and business record-keeping should be separately
maintained.
_____ (c) Ensures that all relevant financial information is reported.
_____ (d) Assumes that the dollar is the “measuring stick” used to report on financial
performance.
_____ (e) Requires that accounting standards be followed for all significant items.
_____ (f) Separates financial information into time periods for reporting purposes.
_____ (g) Requires recognition of expenses in the same period as related revenues.
_____ (h) Indicates that fair value changes subsequent to purchase are not recorded in
the accounts.
E4-3 Here are some accounting reporting situations.
(a) Dorfner Company recognizes revenue at the end of the production cycle but before
sale. The price of the product, as well as the amount that can be sold, is not certain.
(b) Rayms Company is in its fifth year of operation and has yet to issue financial statements. (Do not use the full disclosure principle.)
(c) Tariq, Inc. is carrying inventory at its original cost of $100,000. Inventory has a fair
value of $110,000.
(d) Leer Hospital Supply Corporation reports only current assets and current liabilities
on its balance sheet. Property, plant, and equipment and bonds payable are reported
as current assets and current liabilities, respectively. Liquidation of the company is
unlikely.
(e) Kim Company has inventory on hand that cost $400,000. Kim reports inventory on
its balance sheet at its current fair value of $425,000.
(f) Kris Piwek, president of Classic Music Company, bought a computer for her personal
use. She paid for the computer by using company funds and debited the “Computers”
account.
Instructions
For each situation, list the assumption, principle, or constraint that has been violated, if
any. Some of these assumptions, principles, and constraints were presented in earlier
chapters. List only one answer for each situation.
E4-4 Your examination of the records of a company that follows the cash basis of accounting tells you that the company’s reported cash basis earnings in 2012 are $33,640.
If this firm had followed accrual basis accounting practices, it would have reported the
following year-end balances.
| 2012 $3,400 1,300 |
2011 $2,800 1,460 |
Accounts receivable Supplies on hand |
| Unpaid wages owed | 2,000 | 2,400 |
| Other unpaid amounts | 1,400 | 1,100 |
Instructions
Determine the company’s net earnings on an accrual basis for 2012. Show all your calculations in an orderly fashion.
E4-5 In its first year of operations, Lazirko Company earned $28,000 in service revenue,
$6,000 of which was on account and still outstanding at year-end. The remaining $22,000
was received in cash from customers.
The company incurred operating expenses of $15,800. Of these expenses, $12,000
were paid in cash; $3,800 was still owed on account at year-end. In addition, Lazirko
prepaid $2,400 for insurance coverage that would not be used until the second year of
operations.
Instructions
(a) Calculate the first year’s net earnings under the cash basis of accounting, and calculate the first year’s net earnings under the accrual basis of accounting.
204 chapter 4 Accrual Accounting Concepts
Identify the violated
assumption, principle,
or constraint.
(SO 1), C
Convert earnings from cash
to accrual basis.
(SO 2, 4, 5, 9), AP
Determine cash-basis and
accrual-basis earnings.
(SO 2, 9), AP
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Exercises 205
(b) Which basis of accounting (cash or accrual) provides more useful information for
decision makers?
E4-6 Mt. Horeb Company, a ski tuning and repair shop, opened in November 2011. The
company carefully kept track of all its cash receipts and cash payments. The following
information is available at the end of the ski season, April 30, 2012.
| Cash | Cash | |
| Receipts $20,000 |
Payments | Issue of common shares |
| Payment for repair equipment Rent payments |
$ 9,200 1,225 |
|
| Newspaper advertising payment | 375 | |
| Utility bills payments Part-time helper’s wages payments Income tax payment |
970 2,600 10,000 |
|
| Cash receipts from ski and snowboard repair services |
32,150 |
| Subtotals | 52,150 | 24,370 |
| Cash balance Totals |
27,780 $52,150 |
$52,150 |
You learn that the repair equipment has an estimated useful life of 4 years. The company rents space at a cost of $175 per month on a one-year lease. The lease contract
requires payment of the first and last months’ rent in advance, which was done. The
part-time helper is owed $420 at April 30, 2012, for unpaid wages. At April 30, 2012,
customers owe Mt. Horeb Company $420 for services they have received but have not
yet paid for.
Instructions
(a) Prepare an accrual-basis income statement for the 6 months ended April 30, 2012.
(b) Prepare the April 30, 2012, classified balance sheet.
E4-7 KidVid, a maker of electronic games for kids, has just completed its first year of
operations. The company’s sales growth was explosive. To encourage large national stores
to carry its products, KidVid offered 180-day financing—meaning its largest customers do
not pay for nearly 6 months. Because KidVid is a new company, its components suppliers insist on being paid cash on delivery. Also, it had to pay up front for 2 years of insurance. At the end of the year, KidVid owed employees for one full month of salaries, but
due to a cash shortfall, it promised to pay them the first week of next year.
Instructions
(a) Explain how cash and accrual accounting would differ for each of the events listed
above and describe the proper accrual accounting.
(b) Assume that at the end of the year KidVid reported a favorable net income, yet the
company’s management is concerned because the company is very short of cash. Explain how KidVid could have positive net income and yet run out of cash.
E4-8 Peng Company accumulates the following adjustment data at December 31.
(a) Service Revenue earned but unbilled totals $600.
(b) Store supplies of $160 are on hand. Supplies account shows $1,900 balance.
(c) Utility expenses of $275 are unpaid.
(d) Service revenue of $490 collected in advance has been earned.
(e) Salaries of $620 are unpaid.
(f) Prepaid insurance totaling $400 has expired.
Instructions
For each item, indicate (1) the type of adjustment (prepaid expense, unearned revenue,
accrued revenue, or accrued expense) and (2) the status of the accounts before adjustment (overstated or understated).
E4-9 The ledger of Sagovic Rental Agency on March 31 of the current year includes the
selected accounts on page 206 before adjusting entries have been prepared.
Convert earnings from cash
to accrual basis; prepare
accrual-based financial
statements.
(SO 2, 4, 5, 9), AP
Identify differences between
cash and accrual accounting.
(SO 2, 3, 9), C
Identify types of adjustments
and accounts before
adjustment.
(SO 3, 4, 5), AN
Prepare adjusting entries
from selected account data.
(SO 4, 5), AP
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206 chapter 4 Accrual Accounting Concepts
| Debits $ 3,600 3,000 |
Credits | Prepaid Insurance Supplies |
| Equipment Accumulated Depreciation—Equipment Notes Payable |
25,000 | $ 8,400 20,000 |
| Unearned Rent Revenue | 12,400 | |
| Rent Revenue | 60,000 | |
| Interest Expense | 0 | |
| Salaries and Wages Expense An analysis of the accounts shows the following. 1. The equipment depreciates $280 per month. |
14,000 |
2. Half of the unearned rent revenue was earned during the quarter.
3. Interest of $400 is accrued on the notes payable.
4. Supplies on hand total $850.
5. Insurance expires at the rate of $400 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.
E4-10 Adam Singh, D.D.S., opened an incorporated dental practice on January 1, 2012.
During the first month of operations the following transactions occurred:
1. Performed services for patients who had dental plan insurance. At January 31, $760
of such services was earned but not yet billed to the insurance companies.
2. Utility expenses incurred but not paid prior to January 31 totaled $450.
3. Purchased dental equipment on January 1 for $80,000, paying $20,000 in cash and
signing a $60,000, 3-year note payable (Interest is paid each December 31). The equipment depreciates $400 per month. Interest is $500 per month.
4. Purchased a 1-year malpractice insurance policy on January 1 for $24,000.
5. Purchased $1,750 of dental supplies (recorded as increase to Supplies). On January
31 determined that $550 of supplies were on hand.
Instructions
Prepare the adjusting entries on January 31. Account titles are: Accumulated Depreciation—
Equipment, Depreciation Expense, Service Revenue, Accounts Receivable, Insurance Expense, Interest Expense, Interest Payable, Prepaid Insurance, Supplies, Supplies Expense,
Utilities Expense, and Utilities Payable.
E4-11 The unadjusted trial balance for Sierra Corp. is shown in Illustration 4-4 (page 168).
In lieu of the adjusting entries shown in the text at October 31, assume the following
adjustment data.
1. Supplies on hand at October 31 total $500.
2. Expired insurance for the month is $100.
3. Depreciation for the month is $75.
4. As of October 31, $800 of the previously recorded unearned revenue had been earned.
5. Services provided but unbilled (and no receivable has been recorded) at October 31
are $280.
6. Interest expense accrued at October 31 is $70.
7. Accrued salaries at October 31 are $1,400.
Instructions
Prepare the adjusting entries for the items above.
E4-12 The income statement of Kaleta Co. for the month of July shows net income of $1,500
based on Service Revenue $5,500; Salaries and Wages Expense $2,100; Supplies Expense $900,
and Utilities Expense $500. In reviewing the statement, you discover the following:
1. Insurance expired during July of $350 was omitted.
2. Supplies expense includes $200 of supplies that are still on hand at July 31.
3. Depreciation on equipment of $150 was omitted.
4. Accrued but unpaid wages at July 31 of $360 were not included.
5. Revenue earned but unrecorded totaled $700.
Prepare adjusting entries.
(SO 4, 5), AP
Prepare adjusting entries.
(SO 4, 5), AP
Prepare a correct income
statement.
(SO 1, 4, 5, 6), AP
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Instructions
Prepare a correct income statement for July 2012.
E4-13 This is a partial adjusted trial balance of Fenske Company.
FENSKE COMPANY
Adjusted Trial Balance
January 31, 2012
| Debit $ 700 1,560 |
Credit | Supplies Prepaid Insurance |
| Salaries and Wages Payable Unearned Service Revenue |
$1,060 750 |
|
| Supplies Expense | 950 | |
| Insurance Expense | 520 | |
| Salaries and Wages Expense | 1,800 | |
| Service Revenue | 2,000 |
Instructions
Answer these questions, assuming the year begins January 1.
(a) If the amount in Supplies Expense is the January 31 adjusting entry, and $300 of
supplies was purchased in January, what was the balance in Supplies on January 1?
(b) If the amount in Insurance Expense is the January 31 adjusting entry, and the original insurance premium was for 1 year, what was the total premium and when was
the policy purchased?
(c) If $2,500 of salaries was paid in January, what was the balance in Salaries and Wages
Payable at December 31, 2011?
(d) If $1,800 was received in January for services performed in January, what was the
balance in Unearned Service Revenue at December 31, 2011?
E4-14 A partial adjusted trial balance for Fenske Company is given in E4-13.
Instructions
Prepare the closing entries at January 31, 2012.
E4-15 Selected accounts of Sandin Company are shown here.
Exercises 207
Supplies Expense
| July 31 750 |
Salaries and Wages Payable
| July 31 1,000 |
Salaries and Wages Expense
July 15 1,000
31 1,000
Service Revenue
| July 14 3,800 31 900 31 500 |
Supplies
| July 1 Bal. 1,100 10 200 |
July 31 750 |
Accounts Receivable
| July 31 500 |
Unearned Service Revenue
| July 31 900 | July 1 Bal. 1,500 20 600 |
Instructions
After analyzing the accounts, journalize (a) the July transactions and (b) the adjusting
entries that were made on July 31. (Hint: July transactions were for cash.)
E4-16 The trial balances shown on page 208 are before and after adjustment for Amit
Company at the end of its fiscal year.
Analyze adjusted data.
(SO 1, 4, 5, 6), AN
Prepare closing entries.
(SO 7), AP
Prepare adjusting entries
from analysis of trial balance.
(SO 4, 5, 6), AP
Journalize basic transactions
and adjusting entries.
(SO 4, 5, 6), AN
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208 chapter 4 Accrual Accounting Concepts
Instructions
Prepare the adjusting entries that were made.
E4-17 The adjusted trial balance for Amit Company is given in E4-16.
Instructions
Prepare the income and retained earnings statements for the year and the classified balance sheet at August 31.
E4-18 The adjusted trial balance for Amit Company is given in E4-16.
Instructions
Prepare the closing entries for the temporary accounts at August 31.
Exercises: Set B and
Challenge Exercises
Visit the book’s companion website, at www.wiley.com/college/kimmel, and choose
the Student Companion site to access Exercise Set B and Challenge Exercises.
Problems: Set A
P4-1A The following selected data are taken from the comparative financial statements
of Superior Curling Club. The club prepares its financial statements using the accrual
basis of accounting.
September 30 2012 2011
| Accounts receivable for member dues Unearned sales revenue Service revenue (from member dues) |
$ 15,000 20,000 151,000 |
$ 19,000 23,000 $135,000 |
Dues are billed to members based upon their use of the club’s facilities. Unearned sales
revenues arise from the sale of tickets to events, such as the Skins Game.
AMIT COMPANY
Trial Balance
August 31, 2012
Before After
Adjustment Adjustment
Dr. Cr. Dr. Cr.
Cash $10,900 $10,900
Accounts Receivable 8,800 9,400
Supplies 2,500 500
Prepaid Insurance 4,000 2,500
Equipment 16,000 16,000
Accumulated Depreciation—Equipment $ 3,600 $ 4,800
Accounts Payable 5,800 5,800
Salaries and Wages Payable 0 1,100
Unearned Rent Revenue 1,800 800
Common Stock 10,000 10,000
Retained Earnings 5,500 5,500
Dividends 2,800 2,800
Service Revenue 34,000 34,600
Rent Revenue 12,100 13,100
Salaries and Wages Expense 17,000 18,100
Supplies Expense 0 2,000
Rent Expense 10,800 10,800
Insurance Expense 0 1,500
Depreciation Expense 0 1,200
$72,800 $72,800 $75,700 $75,700
Prepare financial statements
from adjusted trial balance.
(SO 6), AP
Prepare closing entries.
(SO 7), AP
Record transactions on
accrual basis; convert
revenue to cash receipts.
(SO 2, 4, 9), AP
c04AccrualAccountingConcepts.qxd 10/12/10 11:36 AM Page 208
Instructions
(Hint: You will find it helpful to use T accounts to analyze the following data. You
must analyze these data sequentially, as missing information must first be deduced
before moving on. Post your journal entries as you progress, rather than waiting until
the end.)
(a) Prepare journal entries for each of the following events that took place during 2012.
1. Dues receivable from members from 2011 were all collected during 2012.
2. Unearned sales revenue at the end of 2011 was all earned during 2012.
3. Additional tickets were sold for $44,000 cash during 2012; a portion of these were
used by the purchasers during the year. The entire balance remaining in Unearned
Sales Revenue relates to the upcoming Skins Game in 2012.
4. Dues for the 2011–2012 fiscal year were billed to members.
5. Dues receivable for 2012 (i.e., those billed in item (4) above) were partially
collected.
(b) Determine the amount of cash received by the Club from the above transactions during the year ended September 30, 2012.
P4-2A Gil Vogel started his own consulting firm, Vogel Consulting, on June 1, 2012.
The trial balance at June 30 is as follows.
VOGEL CONSULTING
Trial Balance
June 30, 2012
Debit Credit
Cash $ 6,850
Accounts Receivable 7,000
Prepaid Insurance 2,880
Supplies 2,000
Equipment 15,000
Accounts Payable $ 4,230
Unearned Service Revenue 5,200
Common Stock 22,000
Service Revenue 8,300
Salaries and Wages Expense 4,000
Rent Expense 2,000
$39,730 $39,730
In addition to those accounts listed on the trial balance, the chart of accounts for Vogel
also contains the following accounts: Accumulated Depreciation—Equipment, Utilities
Payable, Salaries and Wages Payable, Depreciation Expense, Insurance Expense, Utilities
Expense, and Supplies Expense.
Other data:
1. Supplies on hand at June 30 total $720.
2. A utility bill for $180 has not been recorded and will not be paid until next month.
3. The insurance policy is for a year.
4. $4,100 of unearned service revenue has been earned at the end of the month.
5. Salaries of $1,250 are accrued at June 30.
6. The equipment has a 5-year life with no salvage value and is being depreciated at
$250 per month for 60 months.
7. Invoices representing $3,900 of services performed during the month have not been
recorded as of June 30.
Instructions
(a) Prepare the adjusting entries for the month of June.
(b) Post the adjusting entries to the ledger accounts. Enter the totals from the trial balance as beginning account balances. Use T accounts.
(c) Prepare an adjusted trial balance at June 30, 2012.
Problems: Set A 209
Prepare adjusting entries,
post to ledger accounts, and
prepare adjusted trial
balance.
(SO 4, 5, 6), AP
(b) Cash received $199,000
(b) Service rev. $16,300
(c) Tot. trial
balance $45,310
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210 chapter 4 Accrual Accounting Concepts
P4-3A The Vang Hotel opened for business on May 1, 2012. Here is its trial balance before adjustment on May 31.
VANG HOTEL
Trial Balance
May 31, 2012
Debit Credit
Cash $ 2,500
Prepaid Insurance 1,800
Supplies 2,600
Land 15,000
Buildings 70,000
Equipment 16,800
Accounts Payable $ 4,700
Unearned Rent Revenue 3,300
Mortgage Payable 36,000
Common Stock 60,000
Rent Revenue 9,000
Salaries and Wages Expense 3,000
Utilities Expense 800
Advertising Expense 500
$113,000 $113,000
Other data:
1. Insurance expires at the rate of $450 per month.
2. A count of supplies shows $1,050 of unused supplies on May 31.
3. Annual depreciation is $3,600 on the building and $3,000 on equipment.
4. The mortgage interest rate is 6%. (The mortgage was taken out on May 1.)
5. Unearned rent of $2,500 has been earned.
6. Salaries of $900 are accrued and unpaid at May 31.
Instructions
(a) Journalize the adjusting entries on May 31.
(b) Prepare a ledger using T accounts. Enter the trial balance amounts and post the adjusting entries.
(c) Prepare an adjusted trial balance on May 31.
(d) Prepare an income statement and a retained earnings statement for the month of
May and a classified balance sheet at May 31.
(e) Identify which accounts should be closed on May 31.
P4-4A Rolling Hills Golf Inc. was organized on July 1, 2012. Quarterly financial statements
are prepared. The trial balance and adjusted trial balance on September 30 are shown here.
ROLLING HILLS GOLF INC.
Trial Balance
September 30, 2012
| Unadjusted | Adjusted | ||||
| Dr. $ 6,700 400 |
Cr. | Dr. $ 6,700 1,000 |
Cr. | Cash Accounts Receivable |
|
| Prepaid Rent | 1,800 | 900 | |||
| Supplies | 1,200 | 180 | |||
| Equipment Accumulated Depreciation—Equipment Notes Payable Accounts Payable |
15,000 | 15,000 | $ | 350 5,000 1,070 |
$ 5,000 1,070 |
| Salaries and Wages Payable | 600 | ||||
| Interest Payable | 50 | ||||
| Unearned Rent Revenue | 1,000 | 800 | |||
| Common Stock | 14,000 | 14,000 | |||
| Retained Earnings | 0 | 0 | |||
| Dividends | 600 | 600 |
Prepare adjusting entries,
adjusted trial balance, and
financial statements.
(SO 4, 5, 6, 7), AP
| (c) Rent revenue Tot. adj. trial balance (d) Net income |
$11,500 |
| $114,630 $3,570 |
Prepare adjusting entries and
financial statements; identify
accounts to be closed.
(SO 4, 5, 6, 7), AP
c04AccrualAccountingConcepts.qxd 8/3/10 1:50 PM Page 210
Unadjusted Adjusted
Dr. Cr. Dr. Cr.
Service Revenue 14,100 14,700
Rent Revenue 700 900
Salaries and Wages Expense 8,800 9,400
Rent Expense 900 1,800
Depreciation Expense 350
Supplies Expense 1,020
Utilities Expense 470 470
Interest Expense 50
$35,870 $35,870 $37,470 $37,470
Instructions
(a) Journalize the adjusting entries that were made.
(b) Prepare an income statement and a retained earnings statement for the 3 months
ending September 30 and a classified balance sheet at September 30.
(c) Identify which accounts should be closed on September 30.
(d) If the note bears interest at 12%, how many months has it been outstanding?
P4-5A A review of the ledger of Terrell Company at December 31, 2012, produces these
data pertaining to the preparation of annual adjusting entries.
1. Prepaid Insurance $15,200. The company has separate insurance policies on its buildings and its motor vehicles. Policy B4564 on the building was purchased on July 1,
2011, for $9,600. The policy has a term of 3 years. Policy A2958 on the vehicles was
purchased on January 1, 2012, for $7,200. This policy has a term of 18 months.
2. Unearned Sales Revenue $22,800: The company began selling magazine subscriptions on October 1, 2012, on an annual basis. The selling price of a subscription is
$24. A review of subscription contracts reveals the following.
| Subscription Start Date | Number of Subscriptions |
| October 1 | 250 |
| November 1 | 300 |
| December 1 | 400 |
| 950 |
3. Notes Payable, $40,000: This balance consists of a note for 6 months at an annual
interest rate of 7%, dated October 1.
4. Salaries Payable $0: There are eight salaried employees. Salaries are paid every Friday
for the current week. Five employees receive a salary of $600 each per week, and three
employees earn $700 each per week. Assume December 31 is a Wednesday. Employees
do not work weekends. All employees worked the last 3 days of December.
Instructions
Prepare the adjusting entries at December 31, 2012.
P4-6A Open Road Travel Court was organized on July 1, 2011, by Tiffany Lampkins.
Tiffany is a good manager but a poor accountant. From the trial balance prepared by a
part-time bookkeeper, Tiffany prepared the following income statement for her fourth
quarter, which ended June 30, 2012.
OPEN ROAD TRAVEL COURT
Income Statement
For the Quarter Ended June 30, 2012
Revenues
| Rent revenues | $212,000 |
| Operating expenses | |
| Advertising Salaries and wages |
$ 3,800 80,500 |
| Utilities | 900 |
| Depreciation | 2,700 |
| Maintenance and repairs | 4,300 |
| Total operating expenses Net income |
92,200 $119,800 |
Problems: Set A 211
| (b) Net income Tot. assets |
$2,510 $23,430 |
Prepare adjusting entries.
(SO 4, 5), AP
Prepare adjusting entries
and a corrected income
statement.
(SO 4, 5), AN
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212 chapter 4 Accrual Accounting Concepts
Tiffany suspected that something was wrong with the statement because net income
had never exceeded $30,000 in any one quarter. Knowing that you are an experienced accountant, she asks you to review the income statement and other data.
You first look at the trial balance. In addition to the account balances reported above
in the income statement, the trial balance contains the following additional selected balances at June 30, 2012.
| Supplies Prepaid Insurance |
$ 8,200 14,400 |
| Note Payable You then make inquiries and discover the following. |
14,000 |
1. Travel court rental revenues include advanced rental payments received for summer
occupancy, in the amount of $57,000.
2. There were $1,800 of supplies on hand at June 30.
3. Prepaid insurance resulted from the payment of a one-year policy on April 1, 2012.
4. The mail in July 2012 brought the following bills: advertising for the week of June 24,
$110; repairs made June 18, $4,450; and utilities for the month of June, $215.
5. There are three employees who receive wages that total $300 per day. At June 30,
four days’ wages have been incurred but not paid.
6. The note payable is a 6% note dated May 1, 2012, and due on July 31, 2012.
7. Income tax of $13,400 for the quarter is due in July but has not yet been recorded.
Instructions
(a) Prepare any adjusting journal entries required at June 30, 2012.
| (b) Prepare a correct income statement for the quarter ended June 30, 2012. (c) Explain to Tiffany the generally accepted accounting principles that she did not rec |
(b) Net income | $33,285 |
ognize in preparing her income statement and their effect on her results.
P4-7A On November 1, 2012, the following were the account balances of Tate Equipment Repair.
| Debits $ 2,790 2,910 1,120 10,000 |
Credits | Cash Accounts Receivable Supplies Equipment |
Accumulated Depreciation—Equipment Accounts Payable Unearned Service Revenue Salaries and Wages Payable Common Stock Retained Earnings |
| $ | 500 2,300 400 620 10,000 3,000 |
$16,820 $16,820
During November, the following summary transactions were completed.
| Nov. 8 | Paid $1,220 for salaries due employees, of which $600 is for November and $620 is for October salaries payable. |
10 Received $1,800 cash from customers in payment of account.
12 Received $1,700 cash for services performed in November.
15 Purchased store equipment on account $3,600.
17 Purchased supplies on account $1,300.
20 Paid creditors $2,500 of accounts payable due.
22 Paid November rent $480.
25 Paid salaries $1,000.
27 Performed services on account and billed customers for services provided
$900.
29 Received $750 from customers for services to be provided in the future.
Adjustment data:
1. Supplies on hand are valued at $1,100.
2. Accrued salaries payable are $480.
3. Depreciation for the month is $250.
4. Unearned service revenue of $500 is earned.
Journalize transactions and
follow through accounting
cycle to preparation of
financial statements.
(SO 4, 5, 6), AP
c04AccrualAccountingConcepts.qxd 8/3/10 1:50 PM Page 212
Instructions
(a) Enter the November 1 balances in the ledger accounts. (Use T accounts.)
(b) Journalize the November transactions.
(c) Post to the ledger accounts. Use Service Revenue, Depreciation Expense, Supplies
Expense, Salaries and Wages Expense, and Rent Expense.
(d) Prepare a trial balance at November 30.
(e) Journalize and post adjusting entries.
(f) Prepare an adjusted trial balance.
(g) Prepare an income statement and a retained earnings statement for November and
a classified balance sheet at November 30.
| P4-8A | Dana La Fontsee opened Pro Window Washing Inc. on July 1, 2012. During July |
| the following transactions were completed. | |
| July 1 | Issued 12,000 shares of common stock for $12,000 cash. Purchased used truck for $8,000, paying $2,000 cash and the balance on account. |
| 1 |
3 Purchased cleaning supplies for $900 on account.
5 Paid $1,800 cash on 1-year insurance policy effective July 1.
12 Billed customers $3,700 for cleaning services.
18 Paid $1,000 cash on amount owed on truck and $500 on amount owed on
cleaning supplies.
20 Paid $2,000 cash for employee salaries.
21 Collected $1,600 cash from customers billed on July 12.
25 Billed customers $2,500 for cleaning services.
31 Paid $290 for maintenance of the truck during month.
31 Declared and paid $600 cash dividend.
The chart of accounts for Pro Window Washing contains the following accounts: Cash,
Accounts Receivable, Supplies, Prepaid Insurance, Equipment, Accumulated Depreciation—
Equipment, Accounts Payable, Salaries and Wages Payable, Common Stock, Retained
Earnings, Dividends, Income Summary, Service Revenue, Maintenance and Repairs Expense, Supplies Expense, Depreciation Expense, Insurance Expense, Salaries and Wages
Expense.
Instructions
(a) Journalize the July transactions.
(b) Post to the ledger accounts. (Use T accounts.)
(c) Prepare a trial balance at July 31.
(d) Journalize the following adjustments.
(1) Services provided but unbilled and uncollected at July 31 were $1,700.
(2) Depreciation on equipment for the month was $180.
(3) One-twelfth of the insurance expired.
(4) An inventory count shows $320 of cleaning supplies on hand at July 31.
(5) Accrued but unpaid employee salaries were $400.
(e) Post adjusting entries to the T accounts.
(f) Prepare an adjusted trial balance.
(g) Prepare the income statement and a retained earnings statement for July and a classified balance sheet at July 31.
(h) Journalize and post closing entries and complete the closing process.
(i) Prepare a post-closing trial balance at July 31.
Problems: Set B
P4-1B The following data are taken from the comparative balance sheets of Glenview
Club, which prepares its financial statements using the accrual basis of accounting.
December 31 2012 2011
| Accounts receivable for member fees Unearned service revenue |
$12,000 17,000 |
$18,000 11,000 |
Fees are billed to members based upon their use of the club’s facilities. Unearned service
revenues arise from the sale of gift certificates, which members can apply to their future
Problems: Set B 213
(f) Cash $1,840
Tot. adj. trial
balance $22,680
(g) Net loss $ 1,030
Complete all steps in
accounting cycle.
(SO 4, 5, 6, 7, 8), AP
| (f) Cash (g) Tot. assets |
$5,410 $21,500 |
Record transactions on
accrual basis; convert
revenue to cash receipts.
(SO 2, 4, 9), AP
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214 chapter 4 Accrual Accounting Concepts
use of club facilities. The 2012 income statement for the club showed that service revenue
of $172,000 was earned during the year.
Instructions
(Hint: You will find it helpful to use T accounts to analyze these data.)
(a) Prepare journal entries for each of the following events that took place during 2012.
1. Fees receivable from 2011 were all collected during 2012.
2. Gift certificates outstanding at the end of 2011 were all redeemed during 2012.
3. An additional $40,000 worth of gift certificates were sold during 2012; a portion
of these were used by the recipients during the year; the remainder were still outstanding at the end of 2012.
4. Fees for 2012 were billed to members.
5. Fees receivable for 2012 (i.e., those billed in item (4) above) were partially collected.
(b) Determine the amount of cash received by the club with respect to fees during 2012.
P4-2B Pamela Quinn started her own consulting firm, Quinn Consulting, on May 1,
2012. The trial balance at May 31 is as shown below.
QUINN CONSULTING
Trial Balance
May 31, 2012
Debit Credit
Cash $ 7,500
Accounts Receivable 3,000
Prepaid Insurance 3,600
Supplies 2,500
Equipment 12,000
Accounts Payable $ 3,500
Unearned Service Revenue 4,000
Common Stock 19,100
Service Revenue 7,500
Salaries and Wages Expense 4,000
Rent Expense 1,500
$34,100 $34,100
In addition to those accounts listed on the trial balance, the chart of accounts for Quinn
Consulting also contains the following accounts: Accumulated Depreciation—Equipment,
Salaries and Wages Payable, Depreciation Expense, Insurance Expense, Utilities Expense,
and Supplies Expense.
Other data:
1. $750 of supplies have been used during the month.
2. Utility costs incurred but not paid are $260.
3. The insurance policy is for 2 years.
4. $1,500 of the balance in the Unearned Service Revenue account remains unearned
at the end of the month.
5. Assume May 31 is a Thursday and employees are paid on Fridays. Quinn Consulting
has two employees that are paid $600 each for a 5-day work week.
6. The equipment has a 5-year life with no salvage value and is being depreciated at
$200 per month for 60 months.
7. Invoices representing $1,980 of services performed during the month have not been
recorded as of May 31.
Instructions
(a) Prepare the adjusting entries for the month of May.
(b) Post the adjusting entries to the ledger accounts. Enter the totals from the trial balance as beginning account balances. Use T accounts.
(c) Prepare an adjusted trial balance at May 31, 2012.
(b) Cash
received $184,000
Prepare adjusting entries,
post to ledger accounts, and
prepare an adjusted trial
balance.
(SO 4, 5, 6), AP
(c) Tot. trial
balance $37,500
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P4-3B Maquoketa Valley Resort opened for business on June 1 with eight air-conditioned
units. Its trial balance before adjustment on August 31 is presented here.
MAQUOKETA VALLEY RESORT
Trial Balance
August 31, 2012
Debit Credit
Cash $ 24,600
Prepaid Insurance 5,400
Supplies 4,300
Land 40,000
Buildings 132,000
Equipment 36,000
Accounts Payable $ 6,500
Unearned Rent Revenue 6,800
Mortgage Payable 120,000
Common Stock 100,000
Dividends 5,000
Rent Revenue 80,000
Salaries and Wages Expense 53,000
Utilities Expense 9,400
Maintenance and Repairs Expense 3,600
$313,300 $313,300
Other data:
1. Insurance expires at the rate of $450 per month.
2. A count of supplies on August 31 shows $700 of supplies on hand.
3. Annual depreciation is $6,600 on buildings and $4,000 on equipment.
4. Unearned rent of $5,000 was earned prior to August 31.
5. Salaries of $600 were unpaid at August 31.
6. Rentals of $1,600 were due from tenants at August 31. (Use Accounts Receivable.)
7. The mortgage interest rate is 9% per year. (The mortgage was taken out August 1.)
Instructions
(a) Journalize the adjusting entries on August 31 for the 3-month period June 1–August 31.
(b) Prepare a ledger using T accounts. Enter the trial balance amounts and post the
adjusting entries.
(c) Prepare an adjusted trial balance on August 31.
(d) Prepare an income statement and a retained earnings statement for the 3 months
ended August 31 and a classified balance sheet as of August 31.
(e) Identify which accounts should be closed on August 31.
P4-4B Vedula Advertising Agency was founded by Murali Vedula in January 2007. Presented here are both the adjusted and unadjusted trial balances as of December 31, 2012.
VEDULA ADVERTISING AGENCY
Trial Balance
December 31, 2012
Unadjusted Adjusted
Dr. Cr. Dr. Cr.
Cash $ 11,000 $ 11,000
Accounts Receivable 16,000 19,500
Supplies 9,400 6,500
Prepaid Insurance 3,350 1,790
Equipment 60,000 60,000
Accumulated Depreciation—
Equipment $ 25,000 $ 30,000
Notes Payable 8,000 8,000
Accounts Payable 2,000 2,000
Interest Payable 0 560
Problems: Set B 215
Prepare adjusting entries,
adjusted trial balance, and
financial statements.
(SO 4, 5, 6, 7), AP
(c) Tot. adj. trial
| balance (d) Net income |
$319,050 $11,500 |
Prepare adjusting entries and
financial statements; identify
accounts to be closed.
(SO 4, 5, 6, 7), AP
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216 chapter 4 Accrual Accounting Concepts
Unadjusted Adjusted
Dr. Cr. Dr. Cr.
Unearned Service Revenue 5,000 3,100
Salaries and Wages Payable 0 820
Common Stock 20,000 20,000
Retained Earnings 5,500 5,500
Dividends 10,000 10,000
Service Revenue 57,600 63,000
Salaries and Wages Expense 9,000 9,820
Insurance Expense 1,560
Interest Expense 560
Depreciation Expense 5,000
Supplies Expense 2,900
Rent Expense 4,350 4,350
$123,100 $123,100 $132,980 $132,980
Instructions
(a) Journalize the annual adjusting entries that were made.
(b) Prepare an income statement and a retained earnings statement for the year ended
December 31, and a classified balance sheet at December 31.
(c) Identify which accounts should be closed on December 31.
(d) If the note has been outstanding 10 months, what is the annual interest rate on that
note?
(e) If the company paid $10,500 in salaries in 2012, what was the balance in Salaries
and Wages Payable on December 31, 2011?
P4-5B A review of the ledger of Felipe Company at December 31, 2012, produces the
following data pertaining to the preparation of annual adjusting entries.
1. Salaries and Wages Payable $0: There are eight salaried employees. Salaries are
paid every Friday for the current week. Six employees receive a salary of $800 each
per week, and two employees earn $600 each per week. Assume December 31 is a
Tuesday. Employees do not work weekends. All employees worked the last 2 days
of December.
2. Unearned Rent Revenue $300,000: The company began subleasing office space in its
new building on November 1. Each tenant is required to make a $5,000 security deposit
that is not refundable until occupancy is terminated. At December 31 the company had
the following rental contracts that are paid in full for the entire term of the lease.
| Term (in months) |
Monthly Rent |
Number of Leases |
Date |
| Nov. 1 Dec. 1 |
6 6 |
$4,000 7,500 |
5 4 |
3. Prepaid Advertising $13,200: This balance consists of payments on two advertising
contracts. The contracts provide for monthly advertising in two trade magazines. The
terms of the contracts are as follows.
Number of
Magazine
Contract Date Amount Issues
| A650 B974 |
May 1 Sept. 1 |
$6,000 7,200 |
12 18 |
The first advertisement runs in the month in which the contract is signed.
4. Notes Payable $80,000: This balance consists of a note for 1 year at an annual interest rate of 8%, dated April 1, 2012.
Instructions
Prepare the adjusting entries at December 31, 2012. Show all computations.
| (b) Net income Tot. assets |
$38,810 $68,790 |
Prepare adjusting entries.
(SO 4, 5), AP
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P4-6B The Fly Right Travel Agency was organized on January 1, 2010, by Joe Kirkpatrick.
Joe is a good manager but a poor accountant. From the trial balance prepared by a parttime bookkeeper, Joe prepared the following income statement for the quarter that ended
March 31, 2012.
FLY RIGHT TRAVEL AGENCY
Income Statement
For the Quarter Ended March 31, 2012
Revenues
| Service revenue | $50,000 | |
| Operating expenses | ||
| Advertising Depreciation |
$ 2,600 400 |
|
| Income tax | 1,500 | |
| Salaries and wages | 11,000 | |
| Utilities Net income |
400 | 15,900 $34,100 |
Joe knew that something was wrong with the statement because net income had
never exceeded $8,000 in any one quarter. Knowing that you are an experienced accountant, he asks you to review the income statement and other data.
You first look at the trial balance. In addition to the account balances reported above
in the income statement, the trial balance contains the following additional selected balances at March 31, 2012.
| Supplies Prepaid insurance |
$ 2,900 3,360 |
| Notes payable You then make inquiries and discover the following: |
12,000 |
1. Travel service revenue includes advance payments for cruises, $20,000.
2. There were $800 of supplies on hand at March 31.
3. Prepaid insurance resulted from the payment of a one-year policy on January 1, 2012.
4. The mail on April 1, 2012, brought the utility bill for the month of March’s heat, light,
and power, $210.
5. There are two employees who receive salaries of $80 each per day. At March 31, four
days’ salaries have been incurred but not paid.
6. The note payable is a 6-month, 7% note dated January 1, 2012.
Instructions
(a) Prepare any adjusting journal entries required at March 31, 2012.
(b) Prepare a correct income statement for the quarter ended March 31, 2012.
(c) Explain to Joe the generally accepted accounting principles that he did not recognize in preparing his income statement and their effect on his results.
P4-7B On September 1, 2012, the following were the account balances of Worthington
Equipment Repair.
| Debits $ 4,880 3,420 |
Credits $ 1,600 3,100 |
Cash Accounts Receivable |
Accumulated Depreciation—Equipment Accounts Payable |
| Supplies | 800 | Unearned Service Revenue | 400 |
| Equipment | 15,000 | Salaries and Wages Payable | 700 |
| Common Stock | 10,000 | ||
| Retained Earnings | 8,300 |
| $24,100 | $24,100 |
| During September, the following summary transactions were completed. | |
| Sept. 8 | Paid $1,100 for salaries due employees, of which $400 is for September |
| and $700 is for August salaries payable. Received $1,500 cash from customers in payment of account. |
10 |
12 Received $3,400 cash for services performed in September.
15 Purchased store equipment on account $3,000.
Problems: Set B 217
Prepare adjusting entries
and a corrected income
statement.
(SO 4, 5), AN
(b) Net income $10,100
Journalize transactions and
follow through accounting
cycle to preparation of
financial statements.
(SO 4, 5, 6), AP
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218 chapter 4 Accrual Accounting Concepts
Sept. 17 Purchased supplies on account $2,000.
20 Paid creditors $4,500 of accounts payable due.
22 Paid September rent $520.
25 Paid salaries $1,200.
27 Performed services on account and billed customers for services provided
$2,040.
29 Received $650 from customers for services to be provided in the future.
Adjustment data:
1. Supplies on hand $1,100.
2. Accrued salaries payable $400.
3. Depreciation $200 per month.
4. Unearned service revenue of $280 earned.
Instructions
(a) Enter the September 1 balances in the ledger T accounts.
(b) Journalize the September transactions.
(c) Post to the ledger T accounts. Use Service Revenue, Depreciation Expense, Supplies
Expense, Salaries and Wages Expense, and Rent Expense.
(d) Prepare a trial balance at September 30.
(e) Journalize and post adjusting entries.
(f ) Prepare an adjusted trial balance.
(g) Prepare an income statement and a retained earnings statement for September and
a classified balance sheet at September 30.
P4-8B Gina Balistrieri opened Genie Cleaners on March 1, 2012. During March, the
following transactions were completed.
| Mar. | 1 1 |
Issued 10,000 shares of common stock for $15,000 cash. Purchased used truck for $8,000, paying $3,000 cash and the balance on account. |
3 Purchased cleaning supplies for $1,500 on account.
5 Paid $2,400 cash on a 6-month insurance policy effective March 1.
14 Billed customers $3,700 for cleaning services.
18 Paid $1,500 cash on amount owed on truck and $500 on amount owed
on cleaning supplies.
20 Paid $1,750 cash for employee salaries.
21 Collected $1,600 cash from customers billed on March 14.
28 Billed customers $4,200 for cleaning services.
31 Paid $350 for gas and oil used in truck during month (use Maintenance
and Repairs Expense).
31 Declared and paid a $900 cash dividend.
The chart of accounts for Genie Cleaners contains the following accounts: Cash, Accounts Receivable, Supplies, Prepaid Insurance, Equipment, Accumulated Depreciation—Equipment,
Accounts Payable, Salaries and Wages Payable, Common Stock, Retained Earnings, Dividends, Income Summary, Service Revenue, Maintenance and Repairs Expense, Supplies
Expense, Depreciation Expense, Insurance Expense, Salaries and Wages Expense.
Instructions
(a) Journalize the March transactions.
(b) Post to the ledger accounts. (Use T accounts.)
(c) Prepare a trial balance at March 31.
(d) Journalize the following adjustments.
1. Earned but unbilled revenue at March 31 was $200.
2. Depreciation on equipment for the month was $250.
3. One-sixth of the insurance expired.
4. An inventory count shows $280 of cleaning supplies on hand at March 31.
5. Accrued but unpaid employee salaries were $1,080.
(e) Post adjusting entries to the T accounts.
(f) Prepare an adjusted trial balance.
(g) Prepare the income statement and a retained earnings statement for March and a
classified balance sheet at March 31.
(h) Journalize and post closing entries and complete the closing process.
(i) Prepare a post-closing trial balance at March 31.
(f) Tot. adj. trial
balance $30,590
(g) Tot. assets $24,370
Complete all steps in
accounting cycle.
(SO 4, 5, 6, 7, 8), AP
(f) Tot. adj. trial
balance $28,930
(g) Tot. assets $22,730
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Problems: Set C
Visit the book’s companion website, at www.wiley.com/college/kimmel, and choose the
Student Companion site to access Problem Set C.
Continuing Cookie Chronicle
(Note: This is a continuation of the Cookie Chronicle from Chapters 1 through 3.)
CCC4 Cookie Creations is gearing up for the winter holiday season. During the month
of December 2011, the following transactions occur.
| Dec. 1 | Natalie hires an assistant at an hourly wage of $8 to help with cookie making and some administrative duties. Natalie teaches the class that was booked on November 25. The balance out standing is received. |
| 5 |
8 Cookie Creations receives a check for the amount due from the neighborhood
school for the class given on November 30.
9 Cookie Creations receives $750 in advance from the local school board for five
classes that the company will give during December and January.
15 Pays the cell phone invoice outstanding at November 30.
16 Issues a check to Natalie’s brother for the amount owed for the design of the
website.
19 Receives a deposit of $60 on a cookie class scheduled for early January.
23 Additional revenue earned during the month for cookie-making classes amounts
to $4,000. (Natalie has not had time to account for each class individually.)
$3,000 in cash has been collected and $1,000 is still outstanding. (This is in addition to the December 5 and December 9 transactions.)
23 Additional baking supplies purchased during the month for sugar, flour, and
chocolate chips amount to $1,250 cash.
23 Issues a check to Natalie’s assistant for $800. Her assistant worked approximately 100 hours from the time in which she was hired until December 23.
28 Pays a dividend of $500 to the common shareholder (Natalie).
As of December 31, Cookie Creations’ year-end, the following adjusting entry data are provided.
1. A count reveals that $45 of brochures and posters were used.
2. Depreciation is recorded on the baking equipment purchased in November. The baking equipment has a useful life of 5 years. Assume that 2 months’ worth of depreciation is required.
3. Amortization (which is similar to depreciation) is recorded on the website. (Credit
the Website account directly for the amount of the amortization.) The website is
amortized over a useful life of 2 years and was available for use on December 1.
4. Interest on the note payable is accrued. (Assume that 1.5 months of interest accrued
during November and December.) Round to nearest dollar.
5. One month’s worth of insurance has expired.
6. Natalie is unexpectedly telephoned on December 28 to give a cookie class at the neighborhood community center on December 31. In early January Cookie Creations sends
an invoice for $450 to the community center.
7. A count reveals that $1,025 of baking supplies were used.
8. A cell phone invoice is received for $75. The invoice is for services provided during
the month of December and is due on January 15.
9. Because the cookie-making class occurred unexpectedly on December 28 and is for
such a large group of children, Natalie’s assistant helps out. Her assistant worked 7
hours at a rate of $8 per hour.
10. An analysis of the unearned revenue account reveals that two of the five classes paid for
by the local school board on December 9 still have not been taught by the end of December. The $60 deposit received on December 19 for another class also remains unearned.
Instructions
Using the information that you have gathered and the general ledger accounts that you
have prepared through Chapter 3, plus the new information above, do the following.
(a) Journalize the above transactions.
(b) Post the December transactions. (Use the general ledger accounts prepared in Chapter 3.)
Continuing Cookie Chronicle 219
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220 chapter 4 Accrual Accounting Concepts
(c) Prepare a trial balance at December 31, 2011.
(d) Prepare and post adjusting journal entries for the month of December.
(e) Prepare an adjusted trial balance as of December 31, 2011.
(f ) Prepare an income statement and a retained earnings statement for the 2-month period ending December 31, 2011, and a classified balance sheet as of December 31, 2011.
(g) Prepare and post closing entries as of December 31, 2011.
(h) Prepare a post-closing trial balance.
Financial Reporting and Analysis
FINANCIAL REPORTING PROBLEM: Tootsie Roll Industries, Inc.
BYP4-1 The financial statements of Tootsie Roll are presented in Appendix A at the end of this book.
Instructions
(a) Using the consolidated income statement and balance sheet, identify items that may result
in adjusting entries for deferrals.
(b) Using the consolidated income statement, identify two items that may result in adjusting entries for accruals.
(c) What was the amount of depreciation expense for 2009 and 2008? (You will need to examine the notes to the financial statements or the statement of cash flows.) Where was accumulated depreciation reported?
(d) What was the cash paid for income taxes during 2009, reported at the bottom of the consolidated statement of cash flows? What was income tax expense (provision for income taxes)
for 2009?
COMPARATIVE ANALYSIS PROBLEM: Tootsie Roll vs. Hershey
BYP4-2 The financial statements of The Hershey Company are presented in Appendix B, following the financial statements for Tootsie Roll in Appendix A.
Instructions
(a) Identify two accounts on Hershey’s balance sheet that provide evidence that Hershey uses accrual accounting. In each case, identify the income statement account that would be affected
by the adjustment process.
(b) Identify two accounts on Tootsie Roll’s balance sheet that provide evidence that Tootsie Roll
uses accrual accounting (different from the two you listed for Hershey). In each case, identify
the income statement account that would be affected by the adjustment process.
RESEARCH CASE
BYP4-3 The February 13, 2010, issue of the Wall Street Journal includes an article by Scott
Thurm entitled “For Some Firms, a Case of ‘Quadrophobia’.”
Instructions
Read the article and answer the following.
(a) What method did the study’s authors use to determine that companies were “managing” their
earnings per share calculation?
(b) For the average company in the study, how much would the company have to boost earnings
in order to increase earnings per share by 1/10 of a cent?
(c) What examples did the authors cite of accounting adjustments that companies can make to
boost net income enough that they can round up to the next highest cent? Why aren’t these
methods of adjustment considered illegal?
broadening your perspective
(c) Totals $8,160
| (e) Totals (f) Net income |
$8,804 $3,211 |
(h) Totals $6,065
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Broadening Your Perspective 221
(d) What is an earnings restatement? What relationship did the authors identify about companies
that restate earnings?
(e) What incentive do companies have to round up their earnings per share to the next highest cent?
INTERPRETING FINANCIAL STATEMENTS
BYP4-4 Laser Recording Systems, founded in 1981, produces disks for use in the home market. The
following is an excerpt from Laser Recording Systems’ financial statements (all dollars in thousands).
Instructions
(a) Can you tell from the discussion whether Laser Recording Systems has prepaid its legal expenses and is now making an adjustment to the asset account Prepaid Legal Expenses, or
whether the company is handling the legal expense via an accrued expense adjustment?
(b) Identify each of the adjustments Laser Recording Systems is discussing as one of the four
types of possible adjustments discussed in the chapter. How is net income ultimately affected
by each of the adjustments?
(c) What journal entry did Laser Recording make to record the accrued interest?
FINANCIAL ANALYSIS ON THE WEB
BYP4-5 Purpose: To learn about the functions of the Securities and Exchange Commission (SEC).
Address: www.sec.gov/about/whatwedo.shtml, or go to www.wiley.com/college/kimmel
Instructions
Use the information in this site to answer the following questions.
(a) What event spurred the creation of the SEC? Why was the SEC created?
(b) What are the four divisions of the SEC? Briefly describe the purpose of each.
(c) What are the responsibilities of the chief accountant?
Critical Thinking
DECISION MAKING ACROSS THE ORGANIZATION
BYP4-6 Council Bluff Park was organized on April 1, 2011, by Lori Delzer. Lori is a good manager
but a poor accountant. From the trial balance prepared by a part-time bookkeeper, Lori prepared
the following income statement for the quarter that ended March 31, 2012.
LASER RECORDING SYSTEMS
Management Discussion
Accrued liabilities increased to $1,642 at January 31, from $138 at the end of the previous fiscal year. Compensation and related accruals increased $195 due primarily to
increases in accruals for severance, vacation, commissions, and relocation expenses.
Accrued professional services increased by $137 primarily as a result of legal expenses
related to several outstanding contractual disputes. Other expenses increased $35, of
which $18 was for interest payable.
COUNCIL BLUFF PARK
Income Statement
For the Quarter Ended March 31, 2012
Revenues
Rental revenues $83,000
Operating expenses
Advertising $ 4,200
Wages 27,600
Utilities 1,500
Depreciation 800
Repairs 2,800
Total operating expenses 36,900
Net income $46,100
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Lori knew that something was wrong with the statement because net income had never exceeded
$20,000 in any one quarter. Knowing that you are an experienced accountant, she asks you to
review the income statement and other data.
You first look at the trial balance. In addition to the account balances reported in the income
statement, the ledger contains these selected balances at March 31, 2012.
| Supplies Prepaid Insurance |
$ 4,500 7,200 |
| Notes Payable You then make inquiries and discover the following. |
20,000 |
1. Rental revenues include advanced rentals for summer-month occupancy, $21,000.
2. There were $600 of supplies on hand at March 31.
3. Prepaid insurance resulted from the payment of a 1-year policy on January 1, 2012.
4. The mail on April 1, 2012, brought the following bills: advertising for week of March 24, $110;
repairs made March 10, $1,040; and utilities $240.
5. There are four employees who receive wages totaling $290 per day. At March 31, 3 days’ wages
have been incurred but not paid.
6. The note payable is a 3-month, 7% note dated January 1, 2012.
Instructions
With the class divided into groups, answer the following.
(a) Prepare a correct income statement for the quarter ended March 31, 2012.
(b) Explain to Lori the generally accepted accounting principles that she did not follow in preparing her income statement and their effect on her results.
COMMUNICATION ACTIVITY
BYP4-7 On numerous occasions, proposals have surfaced to put the federal government on the
accrual basis of accounting. This is no small issue because if this basis were used, it would mean
that billions in unrecorded liabilities would have to be booked and the federal deficit would
increase substantially.
Instructions
(a) What is the difference between accrual-basis accounting and cash-basis accounting?
(b) Comment on why politicians prefer a cash-basis accounting system over an accrual-basis system.
(c) Write a letter to your senators explaining why you think the federal government should adopt
the accrual basis of accounting.
ETHICS CASE
BYP4-8 Prism Company is a pesticide manufacturer. Its sales declined greatly this year due to the
passage of legislation outlawing the sale of several of Prism’s chemical pesticides. During the coming year, Prism will have environmentally safe and competitive replacement chemicals to replace
these discontinued products. Sales in the next year are expected to greatly exceed those of any prior
year. Therefore, the decline in this year’s sales and profits appears to be a one-year aberration.
Even so, the company president believes that a large dip in the current year’s profits could
cause a significant drop in the market price of Prism’s stock and make it a takeover target. To avoid
this possibility, he urges Brad Ellis, controller, in making this period’s year-end adjusting entries to
accrue every possible revenue and to defer as many expenses as possible. The president says to
Brad, “We need the revenues this year, and next year we can easily absorb expenses deferred from
this year. We can’t let our stock price be hammered down!” Brad didn’t get around to recording the
adjusting entries until January 17, but she dated the entries December 31 as if they were recorded
then. Brad also made every effort to comply with the president’s request.
Instructions
(a) Who are the stakeholders in this situation?
(b) What are the ethical considerations of the president’s request and Brad’s dating the adjusting
entries December 31?
(c) Can Brad accrue revenues and defer expenses and still be ethical?
“ALL ABOUT YOU” ACTIVITY
BYP4-9 Companies prepare balance sheets in order to know their financial position at a specific
point in time. This enables them to make a comparison to their position at previous points in time
and gives them a basis for planning for the future. In order to evaluate your financial position, you
222 chapter 4 Accrual Accounting Concepts
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can prepare a personal balance sheet. Assume that you have compiled the following information
regarding your finances. (Hint: Some of the items might not be used in your personal balance sheet.)
| Amount owed on student loan balance (long-term) Balance in checking account Certificate of deposit (6-month) Annual earnings from part-time job Automobile Balance on automobile loan (current portion) Balance on automobile loan (long-term portion) Home computer |
$5,000 1,200 3,000 11,300 7,000 1,500 4,000 800 |
| Amount owed to you by younger brother | 300 |
| Balance in money market account | 1,800 |
| Annual tuition | 6,400 |
| Video and stereo equipment Balance owed on credit card (current portion) Balance owed on credit card (long-term portion) |
1,250 150 1,650 |
Instructions
Prepare a personal balance sheet using the format you have learned for a classified balance sheet
for a company. For the equity account, use M. Y. Own, Capital.
FASB CODIFICATION ACTIVITY
BYP4-10 If your school has a subscription to the FASB Codification, go to http://aaahq.org/
ascLogin.cfm to log in and prepare responses to the following.
Instructions
Access the glossary (“Master Glossary”) to answer the following.
(a) What is the definition of revenue?
(b) What is the definition of compensation?
Answers to Insight and Accounting Across the Organization Questions
p. 166 Cooking the Books? Q: What motivates sales executives and finance and accounting executives to participate in activities that result in inaccurate reporting of revenues? A: Sales executives typically receive bonuses based on their ability to meet quarterly sales targets. In addition,
they often face the possibility of losing their jobs if they miss those targets. Executives in accounting and finance are very aware of the earnings targets of Wall Street analysts and investors. If
they fail to meet these targets, the company’s stock price will fall. As a result of these pressures,
executives sometimes knowingly engage in unethical efforts to misstate revenues. As a result of
the Sarbanes-Oxley Act of 2002, the penalties for such behavior are now much more severe.
p. 167 Reporting Revenue Accurately Q: In the past, why was it argued that Apple should spread
the recognition of iPhone revenue over a two-year period, rather than recording it upfront?
A: Apple promises to provide software updates over the life of the phone’s use. Because this represents an unfulfilled service obligation, it was argued that Apple should spread its revenue recognition over a two-year estimated life of the phone.
p. 174 Turning Gift Cards into Revenue Q: Suppose that Robert Jones purchases a $100 gift card
at Best Buy on December 24, 2011, and gives it to his wife, Mary Jones, on December 25, 2011. On
January 3, 2012, Mary uses the card to purchase $100 worth of CDs. When do you think Best Buy
should recognize revenue and why? A: According to the revenue recognition principle, companies
should recognize revenue when earned. In this case, revenue is not earned until Best Buy provides
the goods. Thus, when Best Buy receives cash in exchange for the gift card on December 24, 2011,
it should recognize a liability, Unearned Revenue, for $100. On January 3, 2012, when Mary Jones
exchanges the card for merchandise, Best Buy should recognize revenue and eliminate $100 from
the balance in the Unearned Revenue account.
p. 178 Cashing In on Accrual Accounting Q: Accrual accounting is often considered superior to cash
accounting. Why, then, were some people critical of China’s use of accrual accounting in this instance?
A: In this case, some people were critical because, in general, China uses cash accounting. By switching to accrual accounting for this transaction, China was not being consistent in its accounting practices. Lack of consistency reduces the transparency and usefulness of accounting information.
Answers to Self-Test Questions
1. c 2. a 3. d 4. d 5. d 6. c ($1,350 ! $600 % $750) 7. a 8. c 9. c 10. b 11. b 12. c
13. a 14. a 15. d
Broadening Your Perspective 223
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IFRS A Look at IFRS
It is often difficult for companies to determine in what time period they should report particular
revenues and expenses. Both the IASB and FASB are working on a joint project to develop a common conceptual framework, as well as a revenue recognition project, that will enable companies
to better use the same principles to record transactions consistently over time.
KEY POINTS
• In this chapter, you learned accrual-basis accounting applied under GAAP. Companies applying
IFRS also use accrual-basis accounting to ensure that they record transactions that change a
company’s financial statements in the period in which events occur.
• Similar to GAAP, cash-basis accounting is not in accordance with IFRS.
• IFRS also divides the economic life of companies into artificial time periods. Under both GAAP
and IFRS, this is referred to as the periodicity assumption.
• IFRS requires that companies present a complete set of financial statements, including comparative information annually.
• GAAP has more than 100 rules dealing with revenue recognition. Many of these rules are industryspecific. In contrast, revenue recognition under IFRS is determined primarily by a single
standard. Despite this large disparity in the amount of detailed guidance devoted to revenue
recognition, the general revenue recognition principles required by GAAP that are used in
this textbook are similar to those under IFRS.
• As the Feature Story illustrates, revenue recognition fraud is a major issue in U.S. financial
reporting. The same situation occurs in other countries, as evidenced by revenue recognition
breakdowns at Dutch software company Baan NV, Japanese electronics giant NEC, and Dutch
grocer AHold NV.
• A specific standard exists for revenue recognition under IFRS (IAS 18). In general, the standard
is based on the probability that the economic benefits associated with the transaction will
flow to the company selling the goods, providing the service, or receiving investment income.
In addition, the revenues and costs must be capable of being measured reliably. GAAP uses
concepts such as realized, realizable (that is, it is received, or expected to be received), and earned
as a basis for revenue recognition.
• Under IFRS, revaluation of items such as land and buildings is permitted. IFRS allows depreciation based on revaluation of assets, which is not permitted under GAAP.
• The terminology used for revenues and gains, and expenses and losses, differs somewhat
between IFRS and GAAP. For example, income is defined as:
Increases in economic benefits during the accounting period in the form of inflows or
enhancements of assets or decreases of liabilities that result in increases in equity, other
than those relating to contributions from shareholders.
Income includes both revenues, which arise during the normal course of operating activities,
and gains, which arise from activities outside of the normal sales of goods and services. The
term income is not used this way under GAAP. Instead, under GAAP income refers to the net
difference between revenues and expenses. Expenses are defined as:
Decreases in economic benefits during the accounting period in the form of outflows or
depletions of assets or incurrences of liabilities that result in decreases in equity other than
those relating to distributions to shareholders.
Note that under IFRS, expenses include both those costs incurred in the normal course of operations, as well as losses that are not part of normal operations. This in contrast to GAAP, which
defines each separately.
• The procedures of the closing process are applicable to all companies whether they are using
IFRS or GAAP.
LOOKING TO THE FUTURE
The IASB and FASB are now involved in a joint project on revenue recognition. The purpose of this
project is to develop comprehensive guidance on when to recognize revenue. Presently, the Boards are
considering an approach that focuses on changes in assets and liabilities (rather than on earned and
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realized) as the basis for revenue recognition. It is hoped that this approach will lead to more consistent accounting in this area. For more on this topic, see www.fasb.org/project/revenue_recognition.shtml.
IFRS Self-Test Questions
1. GAAP:
(a) provides very detailed, industry-specific guidance on revenue recognition, compared to the
general guidance provided by IFRS.
(b) provides only general guidance on revenue recognition, compared to the detailed guidance
provided by IFRS.
(c) allows revenue to be recognized when a customer makes an order.
(d) requires that revenue not be recognized until cash is received.
2. Which of the following statements is false?
(a) IFRS employs the periodicity assumption.
(b) IFRS employs accrual accounting.
(c) IFRS requires that revenues and costs must be capable of being measured reliably.
(d) IFRS uses the cash basis of accounting.
3. As a result of the revenue recognition project being undertaken by the FASB and IASB:
(a) revenue recognition will place more emphasis on when revenue is earned.
(b) revenue recognition will place more emphasis on when revenue is realized.
(c) revenue recognition will place more emphasis on when changes occur in assets and liabilities.
(d) revenue will no longer be recorded unless cash has been received.
4. Which of the following is false?
(a) Under IFRS, the term income describes both revenues and gains.
(b) Under IFRS, the term expenses includes losses.
(c) Under IFRS, firms do not engage in the closing process.
(d) IFRS has fewer standards than GAAP that address revenue recognition.
5. Accrual-basis accounting:
(a) is optional under IFRS.
(b) results in companies recording transactions that change a company’s financial statements
in the period in which events occur.
(c) will likely be eliminated as a result of the IASB/FASB joint project on revenue recognition.
(d) is not consistent with the IASB conceptual framework.
IFRS Concepts and Application
IFRS4-1 Compare and contrast the rules regarding revenue recognition under IFRS versus GAAP.
| IFRS4-2 Explain. |
Under IFRS, do the definitions of revenues and expenses include gains and losses? |
INTERNATIONAL FINANCIAL REPORTING PROBLEM: Zetar plc
IFRS4-3 The financial statements of Zetar plc are presented in Appendix C. The company’s complete annual report, including the notes to its financial statements, is available at www.zetarplc.com.
Visit Zetar’s corporate website and answer the following questions from Zetar’s 2009 annual report.
(a) From the notes to the financial statements, how does the company determine the amount
of revenue to record at the time of a sale?
(b) From the notes to the financial statements, how does the company determine whether a
sale has occurred?
(c) Using the consolidated income statement and consolidated statement of financial position,
identify items that may result in adjusting entries for deferrals.
(d) Using the consolidated income statement, identify two items that may result in adjusting
entries for accruals.
Answers to IFRS Self-Test Questions
1. a 2. d 3. c 4. c 5. b
A Look at IFRS 225
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