Keeping Track of Groupons
Who doesn't like buying things at a discount? That's why it's not surprising that three years after it started as a company, Groupon was estimated to be worth $16 billion. This translates into an average increase in value of almost $15 million per day.
Now consider that Groupon had previously been estimated to be worth even more than that. What happened? Well, accounting regulators and investors began to question the way that Groupon had accounted for some of its transactions. But if Groupon sells only coupons (“groupons”), you're probably wondering how hard can it be to accurately account for that? It turns out that accounting for coupons is not as easy as you might think.
First, consider what happens when Groupon makes a sale. Suppose it sells a groupon for $30 for Highrise Hamburgers. When it receives the $30 from the customer, it must turn over half of that amount ($15) to Highrise Hamburgers. So should Groupon record revenue for the full $30 or just $15? Until recently, Groupon recorded the full $30. But, in response to an SEC ruling on the issue, Groupon now records revenue of $15 instead.
A second issue is a matter of timing. When should Groupon record this $15 revenue? Should it record the revenue when it sells the groupon, or must it wait until the customer uses the groupon at Highrise Hamburgers? You can find the answer to this question in the notes to Groupon's financial statements. It recognizes the revenue once “the number of customers who purchase the daily deal exceeds the predetermined threshold, the Groupon has been electronically delivered to the purchaser and a listing of Groupons sold has been made available to the merchant.”
The accounting becomes even more complicated when you consider the company's loyalty programs. Groupon offers free or discounted groupons to its subscribers for doing things such as referring new customers or participating in promotions. These groupons are to be used for future purchases, yet the company must record the expense at the time the customer receives the groupon. The cost of these programs is huge for Groupon, so the timing of this expense can definitely affect its reported income.
The final kicker is that Groupon, like all other companies, must rely on many estimates in its financial reporting. For example, Groupon reports that “estimates are utilized for, but not limited to, stock-based compensation, income taxes, valuation of acquired goodwill and intangible assets, customer refunds, contingent liabilities and the depreciable lives of fixed assets.” It concludes by saying that “actual results could differ materially from those estimates.” So, next time you use a coupon, think about what that means for the company's accountants!
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Read A Look at IFRS p. 157
After studying this chapter, you should be able to:
[1] Explain the time period assumption.
[2] Explain the accrual basis of accounting.
[3] Explain the reasons for adjusting entries 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 an adjusted trial balance.
Preview of Chapter 3
In Chapter 1, you learned a neat little formula: Net income = Revenues − Expenses. In Chapter 2, you learned some rules for recording revenue and expense transactions. Guess what? Things are not really that nice and neat. In fact, it is often difficult for companies to determine in what time period they should report some revenues and expenses. In other words, in measuring net income, timing is everything.
The content and organization of Chapter 3 are as follows.
Timing Issues
If we could wait to prepare financial statements until a company ended its operations, no adjustments would be needed. At that point, we could easily determine its final balance sheet and the amount of lifetime income it earned.
However, most companies need immediate feedback about how well they are doing. For example, management usually wants monthly financial statements. The Internal Revenue Service requires all businesses to file annual tax returns. Therefore, accountants divide the economic life of a business into artificial time periods. This convenient assumption is referred to as the time period assumption.
Many business transactions affect more than one of these arbitrary time periods. For example, the airplanes purchased by Southwest Airlines five years ago are still in use today. We must determine the relevance of each business transaction to specific accounting periods. (How much of the cost of an airplane contributed to operations this year?)
Alternative Terminology
The time period assumption is also called the periodicity assumption.
Fiscal and Calendar Years
Both small and large companies prepare financial statements periodically in order to assess their financial condition and results of operations. Accounting time periods are generally a month, a quarter, or a year. Monthly and quarterly time periods are called interim periods. Most large companies must prepare both quarterly and annual financial statements.
An accounting time period that is one year in length is a fiscal year. A fiscal year usually begins with the first day of a month and ends 12 months later on the last day of a month. Most businesses use the calendar year (January 1 to December 31) as their accounting period. Some do not. Companies whose fiscal year differs from the calendar year include Delta Air Lines, June 30, and Walt Disney Productions, September 30. Sometimes a company's year-end will vary from year to year. For example, PepsiCo's fiscal year ends on the Friday closest to December 31, which was December 25 in 2010 and December 30 in 2011.
Accrual- versus Cash-Basis Accounting
What you will learn in this chapter is accrual-basis accounting. Under the accrual basis, companies record transactions that change a company's financial statements in the periods in which the events occur. For example, using the accrual basis to determine net income means companies recognize revenues when they perform services (rather than when they receive cash). It also means recognizing expenses when incurred (rather than when paid).
An alternative to the accrual basis is the cash basis. Under cash-basis accounting, companies record revenue when they receive cash. They record an expense when they pay out cash. The cash basis seems appealing due to its simplicity, but it often produces misleading financial statements. It fails to record revenue for a company that has performed services but for which it has not received the cash. As a result, it does not match expenses with revenues. Cash-basis accounting is not in accordance with generally accepted accounting principles (GAAP).
Individuals and some small companies do use cash-basis accounting. The cash basis is justified for small businesses because they often have few receivables and payables. Medium and large companies use accrual-basis accounting.
Recognizing Revenues and Expenses
It can be difficult to determine when to report revenues and expenses. The revenue recognition principle and the expense recognition principle help in this task.
REVENUE RECOGNITION PRINCIPLE
When a company agrees to perform a service or sell a product to a customer, it has a performance obligation. When the company meets this performance obligation, it recognizes revenue. The revenue recognition principle therefore requires that companies recognize revenue in the accounting period in which the performance obligation is satisfied.1 To illustrate, assume that Dave's Dry Cleaning cleans clothing on June 30 but customers do not claim and pay for their clothes until the first week of July. Dave's should record revenue in June when it performed the service (satisfied the performance obligation) rather than in July when it received the cash. At June 30, Dave's would report a receivable on its balance sheet and revenue in its income statement for the service performed.
EXPENSE RECOGNITION PRINCIPLE
Accountants follow a simple rule in recognizing expenses: “Let the expenses follow the revenues.” Thus, expense recognition is tied to revenue recognition. In the dry cleaning example, this means that Dave's should report the salary expense incurred in performing the June 30 cleaning service in the same period in which it recognizes the service revenue. The critical issue in expense recognition is when the expense makes its contribution to revenue. This may or may not be the same period in which the expense is paid. If Dave's does not pay the salary incurred on June 30 until July, it would report salaries payable on its June 30 balance sheet.
This 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 3-1 summarizes the revenue and expense recognition principles.
Illustration 3-1
GAAP relationships in revenue and expense recognition
ETHICS INSIGHT 
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, reporting a sale in one period that did not actually occur until the next period in order to achieve the earlier period's sales targets.
What motivates sales executives and finance and accounting executives to participate in activities that result in inaccurate reporting of revenues? (See page 156.)
DO IT!
Timing Concepts
Several timing concepts are discussed on pages 100–101. A list of concepts is provided in the left column below, with a description of the concept in the right column below. There are more descriptions provided than concepts. Match the description of the concept to the concept.
| 1. ____Accrual-basis accounting. | (a) Monthly and quarterly time periods. |
| 2. ____Calendar year. | (b) Efforts (expenses) should be matched with results (revenues). |
| 3. ____Time period assumption. | (c) Accountants divide the economic life of a business into artificial time periods. |
| 4. ____Expense recognition principle. | (d) Companies record revenues when they receive cash and record expenses when they pay out cash. (e) An accounting time period that starts on January 1 and ends on December 31. (f) Companies record transactions in the period in which the events occur. |
Action Plan
Review the glossary terms identified on page 124.
Study carefully the revenue recognition principle, the expense recognition principle, and the time period assumption.
Solution
1. f 2. e 3. c 4. b
Related exercise material: E3-1, E3-2, E3-3, and DO IT! 3-1.
The Basics of Adjusting Entries
Explain the reasons for adjusting entries and identify the major types of adjusting entries.
In order for revenues to be recorded in the period in which services are performed 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.
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.
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.
Types of Adjusting Entries
Adjusting entries are classified as either deferrals or accruals. As Illustration 3-2 shows, each of these classes has two subcategories.
Illustration 3-2
Categories of adjusting entries
Subsequent sections give examples of each type of adjustment. Each example is based on the October 31 trial balance of Pioneer Advertising Agency from Chapter 2, reproduced in Illustration 3-3.
We assume that Pioneer Advertising uses an accounting period of one month. Thus, monthly adjusting entries are made. The entries are dated October 31.
Adjusting Entries for Deferrals
To defer means to postpone or delay. Deferrals are expenses or revenues that are recognized at a date later than the point when cash was originally exchanged. The two types of deferrals are prepaid expenses and unearned revenues.
PREPAID EXPENSES
When companies record payments of expenses that will benefit more than one accounting period, they record an asset 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 3-4, 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.
Illustration 3-4
Adjusting entries for prepaid expenses
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. As shown in Illustration 3-5, 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 2 that Pioneer Advertising Agency purchased supplies costing $2,500 on October 5. Pioneer 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 $1,500 ($2,500 – $1,000). This use of supplies decreases an asset, Supplies. It also decreases owner's equity by increasing an expense account, Supplies Expense. This is shown in Illustration 3-5.
Illustration 3-5
Adjustment for supplies
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 Pioneer does not make the adjusting entry, October expenses are understated and net income is overstated by $1,500. Moreover, both assets and owner's 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, Pioneer Advertising paid $600 for a one-year fire insurance policy. Coverage began on October 1. Pioneer 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 owner's equity by increasing an expense account, Insurance Expense.
As shown in Illustration 3-6 (page 106), 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 Pioneer does not make this adjustment, October expenses are understated by $50 and net income is overstated by $50. Moreover, both assets and owner's equity will be overstated by $50 on the October 31 balance sheet.
Illustration 3-6
Adjustment for insurance
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 1, companies record such assets at cost, as required by the historical 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 Pioneer Advertising, assume that depreciation on the equipment is $480 a year, or $40 per month. As shown in Illustration 3-7, rather than decrease (credit) the asset account directly, Pioneer 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, Pioneer decreases owner's 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.
Helpful Hint All contra accounts have increases, decreases, and normal balances opposite to the account to which they relate.
Statement Presentation. As indicated, 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 been expensed to date. Thus, in the balance sheet, Pioneer deducts Accumulated Depreciation—Equipment from the related asset account, as shown in Illustration 3-8.
Illustration 3-7
Adjustment for depreciation
Illustration 3-8
Balance sheet presentation of accumulated depreciation
Book value is the difference between the cost of any depreciable asset and its related accumulated depreciation. In Illustration 3-8, 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 owner's equity, and net income are overstated by $40 and depreciation expense is understated by $40.
Illustration 3-9 summarizes the accounting for prepaid expenses.
Alternative Terminology
Book value is also referred to as carrying value.
Illustration 3-9
Accounting for prepaid expenses
UNEARNED REVENUES
When companies receive cash before services are performed, they record a liability by increasing (crediting) a liability account called unearned revenues. In other words, a company now has a performance obligation (liability) to transfer a service to one of its customers. Items like rent, magazine subscriptions, 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 performed in a future accounting period, it increases (credits) an unearned revenue (a liability) account to recognize the liability that exists. The company subsequently recognizes revenues when it performs the service. During the accounting period, it is not practical to make daily entries as the company performs services. Instead, the company delays recognition of revenue until the adjustment process. Then, the company makes an adjusting entry to record the revenue for services performed 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 3-10, 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.
Illustration 3-10
Adjusting entries for unearned revenues
Pioneer Advertising received $1,200 on October 2 from R. Knox for advertising services expected to be completed by December 31. Pioneer credited the payment to Unearned Service Revenue. This liability account shows a balance of $1,200 in the October 31 trial balance. From an evaluation of the service Pioneer performed for Knox during October, the company determines that it should recognize $400 of revenue in October. The liability (Unearned Service Revenue) is therefore decreased, and owner's equity (Service Revenue) is increased.
As shown in Illustration 3-11, the liability Unearned Service Revenue now shows a balance of $800. That amount represents the remaining advertising services expected to be performed in the future. At the same time, Service Revenue shows total revenue recognized in October of $10,400. Without this adjustment, revenues and net income are understated by $400 in the income statement. Moreover, liabilities will be overstated and owner's equity will be understated by $400 on the October 31 balance sheet.
Illustration 3-11
Service revenue accounts after adjustment
Illustration 3-12 summarizes the accounting for unearned revenues.
Illustration 3-12
Accounting for unearned revenues
ACCOUNTING ACROSS THE ORGANIZATION 
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 a recent balance sheet, Best Buy reported unearned revenue related to gift cards of $479 million.
Source: Robert Berner, “Gift Cards: No Gift to Investors,” BusinessWeek (March 14, 2005), p. 86.
Suppose that Robert Jones purchases a $100 gift card at Best Buy on December 24, 2013, and gives it to his wife, Mary Jones, on December 25, 2013. On January 3, 2014, Mary uses the card to purchase $100 worth of CDs. When do you think Best Buy should recognize revenue and why? (See page 156.)
Adjusting Entries for Deferrals
The ledger of Hammond Company, on March 31, 2014, includes these selected accounts before adjusting entries are prepared.
An analysis of the accounts shows the following.
1. Insurance expires at the rate of $100 per month.
2. Supplies on hand total $800.
3. The equipment depreciates $200 a month.
4. During March, services were performed for one-half of the unearned service revenue.
Prepare the adjusting entries for the month of March.
Action Plan
Make adjusting entries at the end of the period for revenues recognized 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.
Solution
Related exercise material: BE3-3, BE3-4, BE3-5, BE3-6, and DO IT! 3-2.
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 for services performed 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 performed and the clients will not be billed until the service has been completed.
An adjusting entry records the receivable that exists at the balance sheet date and the revenue for the services performed during the period. Prior to adjustment, both assets and revenues are understated. As shown in Illustration 3-13, 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.
Illustration 3-13
Adjusting entries for accrued revenues
In October, Pioneer Advertising performed services worth $200 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 owner's equity by increasing a revenue account, Service Revenue, as shown in Illustration 3-14.
Illustration 3-14
Adjustment for accrued revenue
The asset Accounts Receivable shows that clients owe Pioneer $200 at the balance sheet date. The balance of $10,600 in Service Revenue represents the total revenue for services performed by Pioneer during the month ($10,000 + $400 + $200). Without the adjusting entry, assets and owner's equity on the balance sheet and revenues and net income on the income statement are understated.
On November 10, Pioneer receives cash of $200 for the services performed in October and makes the following entry.
The company records the collection of the receivables by a debit (increase) to Cash and a credit (decrease) to Accounts Receivable.
Illustration 3-15 summarizes the accounting for accrued revenues.
Equation analyses summarize the effects of transactions on the three elements of the accounting equation, as well as the effect on cash flows.
Illustration 3-15
Accounting for accrued revenues
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, as Illustration 3-16 shows, 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.
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 3-16
Adjusting entries for accrued expenses
Let's look in more detail at some specific types of accrued expenses, beginning with accrued interest.
ACCRUED INTEREST Pioneer Advertising signed a three-month note payable in the amount of $5,000 on October 1. The note requires Pioneer 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 Pioneer, the total interest due on the $5,000 note at its maturity date three months in the future is $150 ($5,000 × 12% × 
), or $50 for one month. Illustration 3-17 shows the formula for computing interest and its application to Pioneer for the month of October.
Illustration 3-17
Formula for computing interest
Helpful Hint In computing interest, we express the time period as a fraction of a year.
As Illustration 3-18 shows, the accrual of interest at October 31 increases a liability account, Interest Payable. It also decreases owner's equity by increasing an expense account, Interest Expense.
Illustration 3-18
Adjustment for accrued interest
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. Pioneer 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 owner's equity are overstated.
INTERNATIONAL INSIGHT
Cashing In on Accrual Accounting
The Chinese government, like most governments, uses cash accounting. A recent report, however, noted that it decided to use accrual accounting versus cash accounting for about $38 billion of expenditures in a recent budget projection. The Chinese government decided to expense the amount in the year in which it was originally allocated rather than when the payments would be made. Why did the Chinese government do this? It enabled the government to keep its projected budget deficit below a 3% threshold. While the Chinese government was able to keep its projected shortfall below 3%, it 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).
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 157.)
ACCRUED SALARIES AND WAGES Companies pay for some types of expenses, such as employee salaries and wages, after the services have been performed. Pioneer paid salaries and wages on October 26 for its employees’ first two weeks of work. The next payment of salaries will not occur until November 9. As Illustration 3-19 shows, three working days remain in October (October 29–31).
Illustration 3-19
Calendar showing Pioneer's pay periods
At October 31, the salaries and wages for these three days represent an accrued expense and a related liability to Pioneer. The employees receive total salaries and wages of $2,000 for a five-day work week, or $400 per day. Thus, accrued salaries and wages at October 31 are $1,200 ($400 × 3). This accrual increases a liability, Salaries and Wages Payable. It also decreases owner's equity by increasing an expense account, Salaries and Wages Expense, as shown in Illustration 3-20.
Illustration 3-20
Adjustment for accrued salaries and wages
After this adjustment, the balance in Salaries and Wages Expense of $5,200 (13 days × $400) is the actual salary and wages expense for October. The balance in Salaries and Wages Payable of $1,200 is the amount of the liability for salaries and wages Pioneer owes as of October 31. Without the $1,200 adjustment for salaries and wages, Pioneer's expenses are understated $1,200 and its liabilities are understated $1,200.
Pioneer Advertising pays salaries and wages every two weeks. Consequently, the next payday is November 9, when the company will again pay total salaries and wages of $4,000. The payment consists of $1,200 of salaries and wages payable at October 31 plus $2,800 of salaries and wages expense for November (7 working days, as shown in the November calendar × $400). Therefore, Pioneer makes the following entry on November 9.
This entry eliminates the liability for Salaries and Wages Payable that Pioneer recorded in the October 31 adjusting entry, and it records the proper amount of Salaries and Wages Expense for the period between November 1 and November 9.
Illustration 3-21 summarizes the accounting for accrued expenses.
Illustration 3-21
Accounting for accrued expenses
PEOPLE, PLANET, AND PROFIT INSIGHT 
Got Junk?
Do you have an old computer or two that you no longer use? How about an old TV that needs replacing? Many people do. Approximately 163,000 computers and televisions become obsolete each day. Yet, in a recent year, only 11% of computers were recycled. It is estimated that 75% of all computers ever sold are sitting in storage somewhere, waiting to be disposed of. Each of these old TVs and computers is loaded with lead, cadmium, mercury, and other toxic chemicals. If you have one of these electronic gadgets, you have a responsibility, and a probable cost, for disposing of it. Companies have the same problem, but their discarded materials may include lead paint, asbestos, and other toxic chemicals.
What accounting issue might this cause for companies? (See page 157.)
DO IT!
Adjusting Entries for Accruals
Micro Computer Services began operations on August 1, 2014. At the end of August 2014, management prepares monthly financial statements. The following information relates to August.
1. At August 31, the company owed its employees $800 in salaries and wages 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 for services performed but unrecorded for August totaled $1,100.
Prepare the adjusting entries needed at August 31, 2014.
Action Plan
Make adjusting entries at the end of the period to recognize revenues for services performed and for expenses incurred.
Don't forget to make adjusting entries for accruals. Adjusting entries for accruals will increase both a balance sheet and an income statement account.
Solution
Related exercise material: BE3-2, BE3-7, E3-5, E3-6, E3-7, E3-8, E3-9, and DO IT! 3-3.
Summary of Basic Relationships
Illustration 3-22 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.
Illustration 3-22
Summary of adjusting entries
Illustrations 3-23 (below) and 3-24 (on page 118) show the journalizing and posting of adjusting entries for Pioneer Advertising Agency on October 31. The ledger identifies all adjustments by the reference J2 because they have been recorded on page 2 of the general journal. The company may insert a center caption “Adjusting Entries” between the last transaction entry and the first adjusting entry in the journal. When you review the general ledger in Illustration 3-24, note that the entries highlighted in color are the adjustments.
Illustration 3-23
General journal showing adjusting entries
Helpful Hint
(1) Adjusting entries should not involve debits or credits to Cash.
(2) Evaluate whether the adjustment makes sense. For example, an adjustment to recognize supplies used should increase Supplies Expense.
(3) Double-check all computations.
(4) Each adjusting entry affects one balance sheet account and one income statement account.
Illustration 3-24
General ledger after adjustment
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 3-25 presents the adjusted trial balance for Pioneer Advertising Agency prepared from the ledger accounts in Illustration 3-24. The amounts affected by the adjusting entries are highlighted in color. Compare these amounts to those in the unadjusted trial balance in Illustration 3-3 on page 103. In this comparison, you will see that there are more accounts in the adjusted trial balance as a result of the adjusting entries made at the end of the month.
Illustration 3-25
Adjusted trial balance
Preparing Financial Statements
Companies can prepare financial statements directly from the adjusted trial balance. Illustrations 3-26 (page 120) and 3-27 (page 121) present the interrelationships of data in the adjusted trial balance and the financial statements.
As Illustration 3-26 shows, companies prepare the income statement from the revenue and expense accounts. Next, they use the owner's capital and drawings accounts and the net income (or net loss) from the income statement to prepare the owner's equity statement.
Illustration 3-26
Preparation of the income statement and owner's equity statement from the adjusted trial balance
As Illustration 3-27 shows, companies then prepare the balance sheet from the asset and liability accounts and the ending owner's capital balance as reported in the owner's equity statement.
Illustration 3-27
Preparation of the balance sheet from the adjusted trial balance
DO IT!
Trial Balance
Skolnick Co. was organized on April 1, 2014. The company prepares quarterly financial statements. The adjusted trial balance amounts at June 30 are shown below.
(a) Determine the net income for the quarter April 1 to June 30.
(b) Determine the total assets and total liabilities at June 30, 2014, for Skolnick Co.
(c) Determine the amount of Owner's Capital at June 30, 2014.
Action Plan
In an adjusted trial balance, all asset, liability, revenue, and expense accounts are properly stated.
To determine the ending balance in Owner's Capital, add net income and subtract dividends.
Solution
Related exercise material: BE3-9, BE3-10, E3-11, E3-12, E3-13, and DO IT! 3-4.
The Green Thumb Lawn Care Company began operations on April 1. At April 30, the trial balance shows the following balances for selected accounts.
| Prepaid Insurance | $ 3,600 |
| Equipment | 28,000 |
| Notes Payable | 20,000 |
| Unearned Service Revenue | 4,200 |
| Service Revenue | 1,800 |
Analysis reveals the following additional data.
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.
4. Seven customers paid for the company's 6-month lawn service package of $600 beginning in April. The company performed services for these customers in April.
5. Lawn services performed for other customers but not recorded at April 30 totaled $1,500.
Instructions
Prepare the adjusting entries for the month of April. Show computations.
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.
Solution to Comprehensive DO IT!
SUMMARY OF LEARNING OBJECTIVES
1 Explain the time period assumption. The time period assumption assumes that the economic life of a business is divided into artificial time periods.
2 Explain the accrual basis of accounting. Accrual-basis accounting means that companies record events that change a company's financial statements in the periods in which those events occur, rather than in the periods in which the company receives or pays cash.
3 Explain the reasons for adjusting entries and identify the major types of adjusting entries. Companies make adjusting entries at the end of an accounting period. Such entries ensure that companies recognize revenues in the period in which the performance obligation is satisfied and recognize expenses in the period in which they are incurred.
The major types of adjusting entries are deferrals (prepaid expenses and unearned revenues), and accruals (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 to record the portion of the prepayment that represents the expense incurred or the revenue for services performed in the current accounting period.
5 Prepare adjusting entries for accruals. Accruals are either accrued revenues or accrued expenses. Companies make adjusting entries for accruals to record revenues for services performed and expenses incurred in the current accounting period that have not been recognized through daily entries.
6 Describe the nature and purpose of an adjusted trial balance. An adjusted trial balance shows the balances of all accounts, including those that have been adjusted, at the end of an accounting period. Its purpose is to prove the equality of the total debit balances and total credit balances in the ledger after all adjustments.
GLOSSARY
Accrual-basis accounting Accounting basis in which companies record transactions that change a company's financial statements in the periods in which the events occur. (p. 100).
Accruals Adjusting entries for either accrued revenues or accrued expenses. (p. 103).
Accrued expenses Expenses incurred but not yet paid in cash or recorded. (p. 112).
Accrued revenues Revenues for services performed but not yet received in cash or recorded. (p. 110).
Adjusted trial balance A list of accounts and their balances after the company has made all adjustments. (p. 119).
Adjusting entries Entries made at the end of an accounting period to ensure that companies follow the revenue recognition and expense recognition principles. (p. 102).
Book value The difference between the cost of a depreciable asset and its related accumulated depreciation. (p. 107).
Calendar year An accounting period that extends from January 1 to December 31. (p. 100).
Cash-basis accounting Accounting basis in which companies record revenue when they receive cash and an expense when they pay cash. (p. 100).
Contra asset account An account offset against an asset account on the balance sheet. (p. 106).
Deferrals Adjusting entries for either prepaid expenses or unearned revenues. (p. 103).
Depreciation The process of allocating the cost of an asset to expense over its useful life. (p. 106).
Expense recognition principle (matching principle) The principle that companies match efforts (expenses) with accomplishments (revenues). (p. 101).
Fiscal year An accounting period that is one year in length. (p. 100).
Interim periods Monthly or quarterly accounting time periods. (p. 100).
Prepaid expenses (prepayments) Expenses paid in cash before they are used or consumed. (p. 104).
Revenue recognition principle The principle that companies recognize revenue in the accounting period in which the performance obligation is satisfied. (p. 101).
Time period assumption An assumption that accountants can divide the economic life of a business into artificial time periods. (p. 100).
Unearned revenues A liability recorded for cash received before services are performed. (p. 108).
Useful life The length of service of a long-lived asset. (p. 106).
APPENDIX 3A Alternative Treatment of Prepaid Expenses and Unearned Revenues
In discussing adjusting entries for prepaid expenses and unearned revenues, we illustrated transactions for which companies made the initial entries to balance sheet accounts. In the case of prepaid expenses, the company debited the prepayment to an asset account. In the case of unearned revenue, the company credited a liability account to record the cash received.
LEARNING OBJECTIVE 7
Prepare adjusting entries for the alternative treatment of deferrals.
Some companies use an alternative treatment. (1) When a company prepays an expense, it debits that amount to an expense account. (2) When it receives payment for future services, it credits the amount to a revenue account. In this appendix, we describe the circumstances that justify such entries and the different adjusting entries that may be required. This alternative treatment of prepaid expenses and unearned revenues has the same effect on the financial statements as the procedures described in the chapter.
Prepaid Expenses
Prepaid expenses become expired costs either through the passage of time (e.g., insurance) or through consumption (e.g., advertising supplies). If at the time of purchase the company expects to consume the supplies before the next financial statement date, it may choose to debit (increase) an expense account rather than an asset account. This alternative treatment is simply more convenient.
Assume that Pioneer Advertising Agency expects that it will use before the end of the month all of the supplies purchased on October 5. A debit of $2,500 to Supplies Expense (rather than to the asset account Supplies) on October 5 will eliminate the need for an adjusting entry on October 31. At October 31, the Supplies Expense account will show a balance of $2,500, which is the cost of supplies used between October 5 and October 31.
But what if the company does not use all the supplies? For example, what if an inventory of $1,000 of advertising supplies remains on October 31? Obviously, the company would need to make an adjusting entry. Prior to adjustment, the expense account Supplies Expense is overstated $1,000, and the asset account Supplies is understated $1,000. Thus, Pioneer makes the following adjusting entry.
After the company posts the adjusting entry, the accounts show:
Illustration 3A-1
Prepaid expenses accounts after adjustment
After adjustment, the asset account Supplies shows a balance of $1,000, which is equal to the cost of supplies on hand at October 31. In addition, Supplies Expense shows a balance of $1,500. This is equal to the cost of supplies used between October 5 and October 31. Without the adjusting entry, expenses are overstated and net income is understated by $1,000 in the October income statement. Also, both assets and owner's equity are understated by $1,000 on the October 31 balance sheet.
Illustration 3A-2 compares the entries and accounts for advertising supplies in the two adjustment approaches.
Illustration 3A-2
Adjustment approaches—a comparison
After Pioneer posts the entries, the accounts appear as follows.
Illustration 3A-3
Comparison of accounts
Note that the account balances under each alternative are the same at October 31: Supplies $1,000 and Supplies Expense $1,500.
Unearned Revenues
Unearned revenues are recognized as revenue at the time services are performed. Similar to the case for prepaid expenses, companies may credit (increase) a revenue account when they receive cash for future services.
To illustrate, assume that Pioneer Advertising received $1,200 for future services on October 2. Pioneer expects to perform the services before October 31.2 In such a case, the company credits Service Revenue. If Pioneer in fact performs the service before October 31, no adjustment is needed.
However, if at the statement date Pioneer has not performed $800 of the services, it would make an adjusting entry. Without the entry, the revenue account Service Revenue is overstated $800, and the liability account Unearned Service Revenue is understated $800. Thus, Pioneer makes the following adjusting entry.
Helpful Hint The required adjusted balances here are Service Revenue $400 and Unearned Service Revenue $800.
After Pioneer posts the adjusting entry, the accounts show:
Illustration 3A-4
Unearned service revenue accounts after adjustment
The liability account Unearned Service Revenue shows a balance of $800. This equals the services that will be performed in the future. In addition, the balance in Service Revenue equals the services performed in October. Without the adjusting entry, both revenues and net income are overstated by $800 in the October income statement. Also, liabilities are understated by $800 and owner's equity is overstated by $800 on the October 31 balance sheet.
Illustration 3A-5 compares the entries and accounts for initially recording unearned service revenue in (1) a liability account or (2) a revenue account.
Illustration 3A-5
Adjustment approaches—a comparison
After Pioneer posts the entries, the accounts appear as follows.
Illustration 3A-6
Comparison of accounts
Note that the balances in the accounts are the same under the two alternatives: Unearned Service Revenue $800 and Service Revenue $400.
Summary of Additional Adjustment Relationships
Illustration 3A-7 provides a summary of basic relationships for deferrals.
Illustration 3A-7
Summary of basic relationships for deferrals
Alternative adjusting entries do not apply to accrued revenues and accrued expenses because no entries occur before companies make these types of adjusting entries.
SUMMARY OF LEARNING OBJECTIVE FOR APPENDIX 3A
7 Prepare adjusting entries for the alternative treatment of deferrals. Companies may initially debit prepayments to an expense account. Likewise, they may credit unearned revenues to a revenue account. At the end of the period, these accounts may be overstated. The adjusting entries for prepaid expenses are a debit to an asset account and a credit to an expense account. Adjusting entries for unearned revenues are a debit to a revenue account and a credit to a liability account.
APPENDIX 3B Concepts in Action
This appendix provides a summary of the concepts in action used in this textbook. In addition, it provides other useful concepts which accountants use as a basis for recording and reporting financial information.
LEARNING OBJECTIVE 8
Discuss financial reporting concepts.
Qualities of Useful Information
Recently, the FASB completed the first phase of a project in which it developed a conceptual framework to serve as the basis for future accounting standards. The framework begins by stating that the primary objective of financial reporting is to provide financial information that is useful to investors and creditors for making decisions about providing capital. Useful information should possess two fundamental qualities, relevance and faithful representation, as shown in Illustration 3B-1.
Illustration 3B-1
Fundamental qualities of useful information
ENHANCING QUALITIES
In addition to the two fundamental qualities, the FASB also describes a number of enhancing qualities of useful information. These include comparability, consistency, verifiability, timeliness, and understandability. In accounting, comparability results when different companies use the same accounting principles. Another characteristic that enhances comparability is consistency. Consistency means that a company uses the same accounting principles and methods from year to year. Information is verifiable if independent observers, using the same methods, obtain similar results. For accounting information to have relevance, it must be timely. That is, it must be available to decision-makers before it loses its capacity to influence decisions. For example, public companies like Google or Best Buy provide their annual reports to investors within 60 days of their year-end. Information has the quality of understandability if it is presented in a clear and concise fashion, so that reasonably informed users of that information can interpret it and comprehend its meaning.
Assumptions in Financial Reporting
To develop accounting standards, the FASB relies on some key assumptions, as shown in Illustration 3B-2. These include assumptions about the monetary unit, economic entity, time period, and going concern.
Illustration 3B-2
Key assumptions in financial reporting
Principles in Financial Reporting
MEASUREMENT PRINCIPLES
GAAP generally uses one of two measurement principles, the historical cost principle or the fair value principle. Selection of which principle to follow generally relates to trade-offs between relevance and faithful representation.
HISTORICAL COST PRINCIPLE The historical cost principle (or cost principle, discussed in Chapter 1) dictates that companies record assets at their cost. This is true not only at the time the asset is purchased but also over the time the asset is held. For example, if land that was purchased for $30,000 increases in value to $40,000, it continues to be reported at $30,000.
FAIR VALUE PRINCIPLE The fair value principle (discussed in Chapter 1) indicates that assets and liabilities should be reported at fair value (the price received to sell an asset or settle a liability). Fair value information may be more useful than historical cost for certain types of assets and liabilities. For example, certain investment securities are reported at fair value because market price information is often readily available for these types of assets. In choosing between cost and fair value, two qualities that make accounting information useful for decision-making are used—relevance and faithful representation. In determining which measurement principle to use, the factual nature of cost figures are weighed versus the relevance of fair value. In general, most assets follow the historical cost principle because fair values may not be representationally faithful. Only in situations where assets are actively traded, such as investment securities, is the fair value principle applied.
REVENUE RECOGNITION PRINCIPLE
The revenue recognition principle requires that companies recognize revenue in the accounting period in which the performance obligation is satisfied. As discussed earlier in the chapter, in a service company, revenue is recognized at the time the service is performed. In a merchandising company, the performance obligation is generally satisfied when the goods transfer from the seller to the buyer (discussed in Chapter 5). At this point, the sales transaction is complete and the sales price established.
EXPENSE RECOGNITION PRINCIPLE
The expense recognition principle (often referred to as the matching principle, discussed earlier in the chapter) dictates that efforts (expenses) be matched with results (revenues). Thus, expenses follow revenues.
FULL DISCLOSURE PRINCIPLE
The full disclosure principle (discussed in Chapter 11) requires that companies disclose all circumstances and events that would make a difference to financial statement users. If an important item cannot reasonably be reported directly in one of the four types of financial statements, then it should be discussed in notes that accompany the statements.
Cost Constraint
Providing information is costly. In deciding whether companies should be required to provide a certain type of information, accounting standard-setters consider the cost constraint. It weighs the cost that companies will incur to provide the information against the benefit that financial statement users will gain from having the information available.
SUMMARY OF LEARNING OBJECTIVE FOR APPENDIX 3B
8 Discuss financial reporting concepts To be judged useful, information should have the primary characteristics of relevance and faithful representation. In addition, it should be comparable, consistent, verifiable, timely, and understandable.
The monetary unit assumption requires that companies include in the accounting records only transaction data that can be expressed in terms of money. The economic entity assumption states that economic events can be identified with a particular unit of accountability. The time period assumption states that the economic life of a business can be divided into artificial time periods and that meaningful accounting reports can be prepared for each period. The going concern assumption states that the company will continue in operation long enough to carry out its existing objectives and commitments.
The historical cost principle states that companies should record assets at their cost. The fair value principle indicates that assets and liabilities should be reported at fair value. The revenue recognition principle requires that companies recognize revenue in the accounting period in which the performance obligation is satisfied. The expense recognition principle dictates that efforts (expenses) be matched with results (revenues). The full disclosure principle requires that companies disclose circumstances and events that matter to financial statement users.
The cost constraint weighs the cost that companies incur to provide a type of information against its benefits to financial statement users.
GLOSSARY FOR APPENDIX 3B
Comparability Ability to compare the accounting information of different companies because they use the same accounting principles. (p. 129).
Consistency Use of the same accounting principles and methods from year to year within a company. (p. 129).
Cost constraint Constraint that weighs the cost that companies will incur to provide the information against the benefit that financial statement users will gain from having the information available. (p. 130).
Economic entity assumption An assumption that every economic entity can be separately identified and accounted for. (p. 129).
Expense recognition principle Efforts (expenses) should be matched with results (revenues). (p. 130). Fair value principle Assets and liabilities should be reported at fair value (the price received to sell an asset or settle a liability). (p. 130).
Faithful representation Information that accurately depicts what really happened. (p. 128).
Full disclosure principle Accounting principle that dictates that companies disclose circumstances and events that make a difference to financial statement users. (p. 130).
Going concern assumption The assumption that the company will continue in operation for the foreseeable future. (p. 129).
Historical cost principle An accounting principle that states that companies should record assets at their cost. (p. 130).
Materiality A company-specific aspect of relevance. An item is material when its size makes it likely to influence the decision of an investor or creditor. (p. 128).
Monetary unit assumption An assumption that requires that only those things that can be expressed in money are included in the accounting records. (p. 129).
Relevance The quality of information that indicates the information makes a difference in a decision. (p. 128).
Revenue recognition principle Companies recognize revenue in the accounting period in which the performance obligation is satisfied. (p. 130).
Timely Information that is available to decision-makers before it loses its capacity to influence decisions. (p. 129).
Time period assumption An assumption that the life of a business can be divided into artificial time periods and that useful reports covering those periods can be prepared for the business. (p. 129).
Understandability Information presented in a clear and concise fashion so that users can interpret it and comprehend its meaning. (p. 129).
Verifiable The quality of information that occurs when independent observers, using the same methods, obtain similar results. (p. 129).
Self-Test, Brief Exercises, Exercises, Problem Set A, and many more components are available for practice in WileyPLUS.
*Note: All asterisked Questions, Exercises, and Problems relate to material in the appendices to the chapter.
SELF-TEST QUESTIONS
Answers are on page 157.
(LO 1)
1. The revenue recognition principle states that:
(a) revenue should be recognized in the accounting period in which a performance obligation is satisfied.
(b) expenses should be matched 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.
(LO 2)
2. The time period assumption states that:
(a) companies must wait until the calendar year is completed to prepare financial statements.
(b) companies use the fiscal year to report financial information.
(c) the economic life of a business can be divided into artificial time periods.
(d) companies record information in the time period in which the events occur.
(LO 2)
3. Which of the following statements about the accrual basis of accounting is false?
(a) Events that change a company's financial statements are recorded in the periods in which the events occur.
(b) Revenue is recognized in the period in which services are performed.
(c) This basis is in accord with generally accepted accounting principles.
(d) Revenue is recorded only when cash is received, and expense is recorded only when cash is paid.
(LO 2)
4. The principle or assumption dictating that efforts (expenses) be matched with accomplishments (revenues) is the:
(a) expense recognition principle.
(b) cost assumption.
(c) time period assumption.
(d) revenue recognition principle.
(LO 3)
5. Adjusting entries are made to ensure that:
(a) expenses are recognized in the period in which they are incurred.
(b) revenues are recorded in the period in which services are performed.
(c) balance sheet and income statement accounts have correct balances at the end of an accounting period.
(d) All the responses above are correct.
(LO 3)
6. Each of the following is a major type (or category) of adjusting entries except:
(a) prepaid expenses.
(b) accrued revenues.
(c) accrued expenses.
(d) recognized revenues.
(LO 4)
7. 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
Supplies Expense
(b) Supplies
Supplies Expense
(c) Supplies Expense
Supplies
(d) Supplies Expense
Supplies
(LO 4)
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.
(LO 4)
9. Accumulated Depreciation is:
(a) a contra asset account.
(b) an expense account.
(c) an owner's equity account.
(d) a liability account.
(LO 4)
10. Rivera 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
Accumulated Depreciation—
Rivera Company
(b) Depreciation Expense
Equipment
(c) Depreciation Expense
Accumulated Depreciation—
Equipment
(d) Equipment Expense
Accumulated Depreciation—
Equipment
(LO 4)
11. Adjustments for unearned revenues:
(a) decrease liabilities and increase revenues.
(b) have an assets and revenues account relationship.
(c) increase assets and increase revenues.
(d) decrease revenues and decrease assets.
(LO 5)
12. Adjustments for accrued revenues:
(a) have a liabilities and revenues account relationship.
(b) have an assets and revenues account relationship.
(c) decrease assets and revenues.
(d) decrease liabilities and increase revenues.
(LO 5)
13. Anika Wilson earned a salary of $400 for the last week of September. She will be paid on October 1. The adjusting entry for Anika's employer at September 30 is:
(a) No entry is required.
(b) Salaries and Wages Expense
Salaries and Wages Payable
(c) Salaries and Wages Expense
Cash
(d) Salaries and Wages Payable
Cash
(LO 6)
14. Which of the following statements 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 lists the account balances segregated by assets and liabilities.
(d) The adjusted trial balance is prepared after the adjusting entries have been journalized and posted.
(LO 7)
*15. The trial balance shows Supplies $0 and Supplies Expense $1,500. If $800 of supplies are on hand at the end of the period, the adjusting entry is:
(a) Debit Supplies $800 and credit Supplies Expense $800.
(b) Debit Supplies Expense $800 and credit Supplies $800.
(c) Debit Supplies $700 and credit Supplies Expense $700.
(d) Debit Supplies Expense $700 and credit Supplies $700.
(LO 8)
*16. Neutrality is an ingredient of:
(LO 8)
*17. Which item is a constraint in financial accounting?
(a) Comparability.
(b) Materiality.
(c) Cost.
(d) Consistency.
Go to the book's companion website, www.wiley.com/college/weygandt, for additional Self-Test Questions.
QUESTIONS
1. (a) How does the time period assumption affect an accountant's analysis of business transactions?
(b) Explain the terms fiscal year, calendar year, and interim periods.
2. Define two generally accepted accounting principles that relate to adjusting the accounts.
3. Susan Zupan, a lawyer, accepts a legal engagement in arch, performs the work in April, and is paid in May. If Zupan's law firm prepares monthly financial statements, when should it recognize revenue from this engagement? Why?
4. Why do accrual-basis financial statements provide more useful information than cash-basis statements?
5. In completing the engagement in Question 3, Zupan pays no costs in March, $2,000 in April, and $2,500 in May (incurred in April). How much expense should the firm deduct from revenues in the month when it recognizes the revenue? Why?
6. “Adjusting entries are required by the historical cost principle of accounting.” Do you agree? Explain.
7. Why may a trial balance not contain up-to-date and complete financial information?
8. Distinguish between the two categories of adjusting entries, and identify the types of adjustments applicable to each category.
9. What is the debit/credit effect of a prepaid expense adjusting entry?
10. “Depreciation is a valuation process that results in the reporting of the fair value of the asset.” Do you agree? Explain.
11. Explain the differences between depreciation expense and accumulated depreciation.
12. J. Brownlee Company purchased equipment for $18,000. By the current balance sheet date, $6,000 had been depreciated. Indicate the balance sheet presentation of the data.
13. What is the debit/credit effect of an unearned revenue adjusting entry?
14. A company fails to recognize revenue for services performed but not yet received in cash or recorded. Which of the following 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.
15. A company fails to recognize an expense incurred but not paid. Indicate which of the following accounts is debited and which is credited in the adjusting entry:
(a) asset, (b) liability, (c) revenue, or (d) expense.
16. A company makes an accrued revenue adjusting entry for $900 and an accrued expense adjusting entry for $700. How much was net income understated prior to these entries? Explain.
17. On January 9, a company pays $5,000 for salaries and wages of which $2,000 was reported as Salaries and Wages Payable on December 31. Give the entry to record the payment.
18. For each of the following items before adjustment, indicate the type of adjusting entry (prepaid expense, unearned revenue, accrued revenue, or 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.
19. 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.
20. “An adjusting entry may affect more than one balance sheet or income statement account.” Do you agree? Why or why not?
21. Why is it possible to prepare financial statements directly from an adjusted trial balance?
*22. Dashan Company debits Supplies Expense for all purchases of supplies and credits Rent Revenue for all advanced rentals. For each type of adjustment, give the adjusting entry.
*23. (a) What is the primary objective of financial reporting?
(b) Identify the characteristics of useful accounting information.
*24. Dan Fineman, the president of King Company, is pleased. King substantially increased its net income in 2014 while keeping its unit inventory relatively the same. Howard Gross, chief accountant, cautions Dan, however. Gross says that since King changed its method of inventory valuation, there is a consistency problem and it is difficult to determine whether King is better off. Is Gross correct? Why or why not?
*25. What is the distinction between comparability and consistency?
*26. Describe the constraint inherent in the presentation of accounting information.
*27. Laurie Belk is president of Better Books. She has no accounting background. Belk cannot understand why fair value is not used as the basis for all accounting measurement and reporting. Discuss.
*28. What is the economic entity assumption? Give an example of its violation.
BRIEF EXERCISES
Indicate why adjusting entries are needed.
(LO 3)
BE3-1 The ledger of Jung 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.
Identify the major types of adjusting entries.
(LO 3, 4, 5)
BE3-2 Moteki Company accumulates the following adjustment data at December 31. Indicate (a) the type of adjustment (prepaid expense, accrued revenues and so on), and (b) the status of accounts before adjustment (overstated or understated).
1. Supplies of $100 are on hand.
2. Services provided but not recorded total $900.
3. Interest of $200 has accumulated on a note payable.
4. Rent collected in advance totaling $650 has been earned.
Prepare adjusting entry for supplies.
(LO 4)
BE3-3 Ritter Advertising Company's trial balance at December 31 shows Supplies $6,700 and Supplies Expense $0. On December 31, there are $2,500 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.
Prepare adjusting entry for depreciation.
(LO 4)
BE3-4 At the end of its first year, the trial balance of Nygaard Company shows Equipment $30,000 and zero balances in Accumulated Depreciation—Equipment and Depreciation Expense. Depreciation for the year is estimated to be $4,000. 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.
Prepare adjusting entry for prepaid expense.
(LO 4)
BE3-5 On July 1, 2014, Dobbs Co. pays $14,400 to Kalter Insurance Co. for a 3-year insurance contract. Both companies have fiscal years ending December 31. For Dobbs Co., journalize and post the entry on July 1 and the adjusting entry on December 31.
Prepare adjusting entry for unearned revenue.
(LO 4)
BE3-6 Using the data in BE3-5, journalize and post the entry on July 1 and the adjusting entry on December 31 for Kalter Insurance Co. Kalter uses the accounts Unearned Service Revenue and Service Revenue.
Prepare adjusting entries for accruals.
(LO 5)
BE3-7 The bookkeeper for Bradbury Company asks you to prepare the following accrued adjusting entries at December 31.
1. Interest on notes payable of $400 is accrued.
2. Services performed but not recorded total $1,900.
3. Salaries earned by employees of $900 have not been recorded.
Use the following account titles: Service Revenue, Accounts Receivable, Interest Expense, Interest Payable, Salaries and Wages Expense, and Salaries and Wages Payable.
Analyze accounts in an unadjusted trial balance.
(LO 3, 4, 5)
BE3-8 The trial balance of Yewlett Company includes the following balance sheet accounts, which may require adjustment. For each account that requires adjustment, indicate (a) the type of adjusting entry (prepaid expenses, unearned revenues, accrued revenues, and accrued expenses) and (b) the related account in the adjusting entry.
| Accounts Receivable | Interest Payable |
| Prepaid Insurance | Unearned Service Revenue |
| Accumulated Depreciation—Equipment |
Prepare an income statement from an adjusted trial balance.
(LO 6)
BE3-9 The adjusted trial balance of Parsons Company at December 31, 2014, includes the following accounts: Owner's Capital $15,600, Owner's Drawings $7,000, Service Revenue $37,000, Salaries and Wages Expense $16,000, Insurance Expense $2,000, Rent Expense $4,000, Supplies Expense $1,500, and Depreciation Expense $1,300. Prepare an income statement for the year.
Prepare an owner's equity statement from an adjusted trial balance.
(LO 6)
BE3-10 Partial adjusted trial balance data for Parsons Company is presented in BE3-9. The balance in Owner's Capital is the balance as of January 1. Prepare an owner's equity statement for the year assuming net income is $12,200 for the year.
Prepare adjusting entries under alternative treatment of deferrals.
(LO 7)
*BE3-11 Mayes Company records all prepayments in income statement accounts. At April 30, the trial balance shows Supplies Expense $2,800, Service Revenue $9,200, and zero balances in related balance sheet accounts. Prepare the adjusting entries at April 30 assuming (a) $700 of supplies on hand and (b) $3,000 of service revenue should be reported as unearned.
Identify characteristics of useful information.
(LO 8)
*BE3-12 The accompanying chart shows the qualitative characteristics of useful accounting information. Fill in the blanks.
Identify characteristics of useful information.
(LO 8)
*BE3-13 Given the characteristics of useful accounting information, complete each of the following statements.
(a) For information to be _____, it should have predictive value, confirmatory value, and be material.
(b) _____ is the quality of information that gives assurance that the information accurately depicts what really happened.
(c) _____ means using the same accounting principles and methods from year to year within a company.
Identify characteristics of useful information.
(LO 8)
*BE3-14 Here are some qualitative characteristics of useful accounting information:
1. Predictive value
2. Neutral
3. Verifiable
4. Timely
Match each qualitative characteristic to one of the following statements.
________ (a) Accounting information should help provide accurate expectations about future events.
________ (b) Accounting information cannot be selected, prepared, or presented to favor one set of interested users over another.
________ (c) The quality of information that occurs when independent observers, using the same methods, obtain similar results.
________ (d) Accounting information must be available to decision-makers before it loses its capacity to influence their decisions.
Define full disclosure principle.
(LO 8)
*BE3-15 The full disclosure principle dictates that:
(a) financial statements should disclose all assets at their cost.
(b) financial statements should disclose only those events that can be measured in currency.
(c) financial statements should disclose all events and circumstances that would matter to users of financial statements.
(d) financial statements should not be relied on unless an auditor has expressed an unqualified opinion on them.
DO IT! Review
Identify timing concepts.
(LO 1, 2)
DO IT! 3-1 Several timing concepts are discussed on pages 100–101. A list of concepts is provided below in the left column, with a description of the concept in the right column. There are more descriptions provided than concepts. Match the description of the concept to the concept.
| 1. ____ Cash-basis accounting. | (a) Monthly and quarterly time periods. |
| 2. ____ Fiscal year. | (b) Accountants divide the economic life of a business into artificial time periods. |
| 3. ____ Revenue recognition principle. | (c) Efforts (expenses) should be matched with accomplishments (revenues). |
| 4. ____ Expense recognition principle. | (d) Companies record revenues when they receive cash and record expenses when they pay out cash. (e) An accounting time period that is one year in length. (f) An accounting time period that starts on January 1 and ends on December 31. (g) Companies record transactions in the period in which the events occur. (h) Recognize revenue in the accounting period in which a performance obligation is satisfied. |
Prepare adjusting entries for deferrals.
(LO 4)
DO IT! 3-2 The ledger of Herrera, Inc. on March 31, 2014, includes the following selected accounts before adjusting entries.
An analysis of the accounts shows the following.
1. Insurance expires at the rate of $300 per month.
2. Supplies on hand total $1,100.
3. The equipment depreciates $500 per month.
4. During March, services were performed for two-fifths of the unearned service revenue.
Prepare the adjusting entries for the month of March.
Prepare adjusting entries for accruals.
(LO 5)
DO IT! 3-3 Javier Computer Services began operations in July 2014. At the end of the month, the company prepares monthly financial statements. It has the following information for the month.
1. At July 31, the company owed employees $1,300 in salaries that the company will pay in August.
2. On July 1, the company borrowed $20,000 from a local bank on a 10-year note. The annual interest rate is 12%.
3. Service revenue unrecorded in July totaled $2,400.
Prepare the adjusting entries needed at July 31, 2014.
Calculate amounts from trial balance.
(LO 6)
DO IT! 3-4 Lumina Co. was organized on April 1, 2014. The company prepares quarterly financial statements. The adjusted trial balance amounts at June 30 are shown below.
(a) Determine the net income for the quarter April 1 to June 30.
(b) Determine the total assets and total liabilities at June 30, 2014 for Lumina Company.
(c) Determine the amount that appears for Owner's Capital at June 30, 2014.
EXERCISES
Explain the time period assumption.
(LO 1)
E3-1 Ian Muse has prepared the following list of statements about the time period assumption.
1. Adjusting entries would not be necessary if a company's life were not divided into artificial time periods.
2. The IRS requires companies to file annual tax returns.
3. Accountants divide the economic life of a business into artificial time periods, but each transaction affects only one of these periods.
4. Accounting time periods are generally a month, a quarter, or a year.
5. A time period lasting one year is called an interim period.
6. All fiscal years are calendar years, but not all calendar years are fiscal years.
Instructions
Identify each statement as true or false. If false, indicate how to correct the statement.
Distinguish between cash and accrual basis of accounting.
(LO 2)
E3-2 On numerous occasions, proposals have surfaced to put the federal government on the accrual basis of accounting. This is no small issue. 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.
(a) What is the difference between accrual-basis accounting and cash-basis accounting?
(b) Why would politicians prefer the cash basis over the accrual basis?
(c) Write a letter to your senator explaining why the federal government should adopt the accrual basis of accounting.
Compute cash and accrual accounting income.
(LO 2)
E3-3 Primo Industries collected $105,000 from customers in 2014. Of the amount collected, $25,000 was for services performed in 2013. In addition, Primo performed services worth $40,000 in 2014, which will not be collected until 2015.
Primo Industries also paid $72,000 for expenses in 2014. Of the amount paid, $30,000 was for expenses incurred on account in 2013. In addition, Primo incurred $42,000 of expenses in 2014, which will not be paid until 2015.
Instructions
(a) Compute 2014 cash-basis net income.
(b) Compute 2014 accrual-basis net income.
Identify the type of adjusting entry needed.
(LO 3, 4, 5)
E3-4 Hart Corporation encounters the following situations:
1. Hart collects $1,300 from a customer in 2014 for services to be performed in 2015.
2. Hart incurs utility expense which is not yet paid in cash or recorded.
3. Hart's employees worked 3 days in 2014 but will not be paid until 2015.
4. Hart performs services for customers but has not yet received cash or recorded the transaction.
5. Hart paid $2,400 rent on December 1 for the 4 months starting December 1.
6. Hart received cash for future services and recorded a liability until the service was performed.
7. Hart performed consulting services for a client in December 2014. On December 31, it had not billed the client for services provided of $1,200.
8. Hart paid cash for an expense and recorded an asset until the item was used up.
9. Hart purchased $900 of supplies in 2014; at year-end, $400 of supplies remain unused.
10. Hart purchased equipment on January 1, 2014; the equipment will be used for 5 years.
11. Hart borrowed $10,000 on October 1, 2014, signing an 8% one-year note payable.
Instructions
Identify what type of adjusting entry (prepaid expense, unearned revenue, accrued expense, or accrued revenue) is needed in each situation at December 31, 2014.
Prepare adjusting entries from selected data.
(LO 4, 5)
E3-5 Verne Cova Company has the following balances in selected accounts on December 31, 2014.
All the accounts have normal balances. The information below has been gathered at December 31, 2014.
1. Verne Cova Company borrowed $10,000 by signing a 12%, one-year note on September 1, 2014.
2. A count of supplies on December 31, 2014, indicates that supplies of $900 are on hand.
3. Depreciation on the equipment for 2014 is $1,000.
4. Verne Cova Company paid $2,100 for 12 months of insurance coverage on June 1, 2014.
5. On December 1, 2014, Verne Cova collected $30,000 for consulting services to be performed from December 1, 2014, through March 31, 2015.
6. Verne Cova performed consulting services for a client in December 2014. The client will be billed $4,200.
7. Verne Cova Company pays its employees total salaries of $9,000 every Monday for the preceding 5-day week (Monday through Friday). On Monday, December 29, employees were paid for the week ending December 26. All employees worked the last 3 days of 2014.
Prepare adjusting entries for the seven items described above.
Identify types of adjustments and account relationships.
(LO 3, 4, 5)
E3-6 Lei Company accumulates the following adjustment data at December 31.
1. Services performed but not recorded total $1,000.
2. Supplies of $300 have been used.
3. Utility expenses of $225 are unpaid.
4. Services related to unearned service revenue of $260 were performed.
5. Salaries of $800 are unpaid.
6. Prepaid insurance totaling $350 has expired.
Instructions
For each of the above items indicate the following.
(a) The type of adjustment (prepaid expense, unearned revenue, accrued revenue, or accrued expense).
(b) The status of accounts before adjustment (overstatement or understatement).
Prepare adjusting entries from selected account data.
(LO 4, 5)
E3-7 The ledger of Perez Rental Agency on March 31 of the current year includes the selected accounts, shown below, before adjusting entries have been prepared.
Prepare adjusting entries.
(LO 4, 5)
An analysis of the accounts shows the following.
1. The equipment depreciates $400 per month.
2. One-third of the unearned rent revenue was earned during the quarter.
3. Interest of $500 is accrued on the notes payable.
4. Supplies on hand total $900.
5. Insurance expires at the rate of $200 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.
Prepare adjusting entries.
(LO 4, 5)
E3-8 Robin Shalit, D.D.S., opened a dental practice on January 1, 2014. During the first month of operations, the following transactions occurred.
1. Performed services for patients who had dental plan insurance. At January 31, $875 of such services were performed but not yet recorded.
2. Utility expenses incurred but not paid prior to January 31 totaled $650.
3. Purchased dental equipment on January 1 for $80,000, paying $20,000 in cash and signing a $60,000, 3-year note payable. The equipment depreciates $400 per month. Interest is $500 per month.
4. Purchased a one-year malpractice insurance policy on January 1 for $24,000.
5. Purchased $1,600 of dental supplies. On January 31, determined that $400 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.
Prepare adjusting entries.
(LO 4, 5)
E3-9 The trial balance for Pioneer Advertising Agency is shown in Illustration 3-3 (page 103). Instead 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 $50.
4. Services related to unearned service revenue in October worth $600 were performed.
5. Services performed but not recorded at October 31 are $300.
6. Interest accrued at October 31 is $95.
7. Accrued salaries at October 31 are $1,625.
Instructions
Prepare the adjusting entries for the items above.
Prepare correct income statement.
(LO 2, 4, 5, 6)
E3-10 The income statement of Gopitkumar Co. for the month of July shows net income of $1,400 based on Service Revenue $5,500, Salaries and Wages Expense $2,300, Supplies Expense $1,200, and Utilities Expense $600. In reviewing the statement, you discover the following.
1. Insurance expired during July of $400 was omitted.
2. Supplies expense includes $250 of supplies that are still on hand at July 31.
3. Depreciation on equipment of $150 was omitted.
4. Accrued but unpaid salaries and wages at July 31 of $300 were not included.
5. Services performed but unrecorded totaled $650.
Instructions
Prepare a correct income statement for July 2014.
Analyze adjusted data.
(LO 3, 4, 5, 6)
E3-11 A partial adjusted trial balance of Gehring Company at January 31, 2014, shows the following.
Instructions
Answer the following questions, assuming the year begins January 1.
(a) If the amount in Supplies Expense is the January 31 adjusting entry, and $1,000 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 one year, what was the total premium and when was the policy purchased?
(c) If $3,500 of salaries was paid in January, what was the balance in Salaries and Wages Payable at December 31, 2013?
Journalize basic transactions and adjusting entries.
(LO 4, 5, 6)
E3-12 Selected accounts of Koffman Company are shown below and on the next page.
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.)
Prepare adjusting entries from analysis of trial balances.
(LO 4, 5, 6)
E3-13 The trial balances before and after adjustment for Frinzi Company at the end of its fiscal year are presented below.
Instructions
Prepare the adjusting entries that were made.
Prepare financial statements from adjusted trial balance.
(LO 6)
E3-14 The adjusted trial balance for Frinzi Company is given in E3-13.
Instructions
Prepare the income and owner's equity statements for the year and the balance sheet at August 31.
Record transactions on accrual basis; convert revenue to cash receipts.
(LO 4, 5)
E3-15 The following data are taken from the comparative balance sheets of Cascade Billiards Club, which prepares its financial statements using the accrual basis of accounting.
Members are billed 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 use of club facilities. The 2014 income statement for the club showed that service revenue of $161,000 was earned during the year.
Instructions
(Hint: You will probably 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 2014.
(1) Accounts receivable from 2013 were all collected.
(2) Gift certificates outstanding at the end of 2013 were all redeemed.
(3) An additional $38,000 worth of gift certificates were sold during 2014. A portion of these was used by the recipients during the year; the remainder was still outstanding at the end of 2014.
(4) Services performed for members for 2014 were billed to members.
(5) Accounts receivable for 2014 (i.e., those billed in item [4] above) were partially collected.
(b) Determine the amount of cash received by the club, with respect to member services, during 2014.
Journalize adjusting entries.
(LO 7)
*E3-16 Aaron Lynch Company has the following balances in selected accounts on December 31, 2014.
| Service Revenue | $40,000 |
| Insurance Expense | 2,700 |
| Supplies Expense | 2,450 |
All the accounts have normal balances. Aaron Lynch Company debits prepayments to expense accounts when paid, and credits unearned revenues to revenue accounts when received. The following information below has been gathered at December 31, 2014.
1. Aaron Lynch Company paid $2,700 for 12 months of insurance coverage on June 1, 2014.
2. On December 1, 2014, Aaron Lynch Company collected $40,000 for consulting services to be performed from December 1, 2014, through March 31, 2015.
3. A count of supplies on December 31, 2014, indicates that supplies of $900 are on hand.
Instructions
Prepare the adjusting entries needed at December 31, 2014.
Journalize transactions and adjusting entries.
(LO 7)
*E3-17 At Cambridge Company, prepayments are debited to expense when paid, and unearned revenues are credited to revenue when cash is received. During January of the current year, the following transactions occurred.
| Jan. | 2 | Paid $1,920 for fire insurance protection for the year. |
| 10 | Paid $1,700 for supplies. | |
| 15 | Received $6,100 for services to be performed in the future. |
On January 31, it is determined that $2,500 of the services were performed and that there are $650 of supplies on hand.
Instructions
(a) Journalize and post the January transactions. (Use T-accounts.)
(b) Journalize and post the adjusting entries at January 31.
(c) Determine the ending balance in each of the accounts.
Identify accounting assumptions and principles.
(LO 8)
*E3-18 Presented below are the assumptions and principles discussed in this chapter.
1. Full disclosure principle.
2. Going concern assumption.
3. Monetary unit assumption.
4. Time period assumption.
5. Historical cost principle.
6. Economic entity assumption.
Instructions
Identify by number the accounting assumption or principle that is described below. Do not use a number more than once.
_______ (a) Is the rationale for why plant assets are not reported at liquidation value.
(Note: Do not use the historical cost principle.)
_______ (b) Indicates that personal and business record-keeping should be separately maintained.
_______ (c) Assumes that the monetary unit is the “measuring stick” used to report on financial performance.
_______ (d) Separates financial information into time periods for reporting purposes.
_______ (e) Measurement basis used when a reliable estimate of fair value is not available.
_______ (f) Dictates that companies should disclose all circumstances and events that make a difference to financial statement users.
Identify the assumption or principle that has been violated.
(LO 8)
*E3-19 Rosman Co. had three major business transactions during 2014.
(a) Reported at its fair value of $260,000 merchandise inventory with a cost of $208,000.
(b) The president of Rosman Co., Jay Rosman, purchased a truck for personal use and charged it to his expense account.
(c) Rosman Co. wanted to make its 2014 income look better, so it added 2 more weeks to the year (a 54-week year). Previous years were 52 weeks.
Instructions
In each situation, identify the assumption or principle that has been violated, if any, and discuss what the company should have done.
Identity financial accounting concepts and principles.
(LO 8)
*E3-20 The following characteristics, assumptions, principles, or constraint guide the FASB when it creates accounting standards.
| Relevance | Expense recognition principle |
| Faithful representation | Time period assumption |
| Comparability | Going concern assumption |
| Consistency | Historical cost principle |
| Monetary unit assumption | Full disclosure principle |
| Economic entity assumption | Materiality |
Match each item above with a description below.
1. ________ Ability to easily evaluate one company's results relative to another's.
2. ________ Belief that a company will continue to operate for the foreseeable future.
3. ________ The judgment concerning whether an item's size is large enough to matter to decision-makers.
4. ________ The reporting of all information that would make a difference to financial statement users.
5. ________ The practice of preparing financial statements at regular intervals.
6. ________ The quality of information that indicates the information makes a difference in a decision.
7. ________ A belief that items should be reported on the balance sheet at the price that was paid to acquire them.
8. ________ A company's use of the same accounting principles and methods from year to year.
9. ________ Tracing accounting events to particular companies.
10. ________ The desire to minimize bias in financial statements.
11. ________ Reporting only those things that can be measured in monetary units.
12. ________ Dictates that efforts (expenses) be matched with results (revenues).
Comment on the objective and qualitative characteristics of accounting information.
(LO 8)
*E3-21 Net Nanny Software International Inc., headquartered in Vancouver, Canada, specializes in Internet safety and computer security products for both the home and commercial markets. In a recent balance sheet, it reported a deficit of US$5,678,288. It has reported only net losses since its inception. In spite of these losses, Net Nanny's shares of stock have traded anywhere from a high of $3.70 to a low of $0.32 on the Canadian Venture Exchange.
Net Nanny's financial statements have historically been prepared in Canadian dollars. Recently, the company adopted the U.S. dollar as its reporting currency.
Instructions 
(a) What is the objective of financial reporting? How does this objective meet or not meet Net Nanny's investors’ needs?
(b) Why would investors want to buy Net Nanny's shares if the company has consistently reported losses over the last few years? Include in your answer an assessment of the relevance of the information reported on Net Nanny's financial statements.
(c) Comment on how the change in reporting information from Canadian dollars to U.S. dollars likely affected the readers of Net Nanny's financial statements. Include in your answer an assessment of the comparability of the information.
Comment on the objective and qualitative characteristics of financial reporting.
(LO 8)
*E3-22 A friend of yours, Ana Gehrig, recently completed an undergraduate degree in science and has just started working with a biotechnology company. Ana tells you that the owners of the business are trying to secure new sources of financing which are needed in order for the company to proceed with development of a new health-care product. Ana said that her boss told her that the company must put together a report to present to potential investors.
Ana thought that the company should include in this package the detailed scientific findings related to the Phase I clinical trials for this product. She said, “I know that the biotech industry sometimes has only a 10% success rate with new products, but if we report all the scientific findings, everyone will see what a sure success this is going to be! The president was talking about the importance of following some set of accounting principles. Why do we need to look at some accounting rules? What they need to realize is that we have scientific results that are quite encouraging, some of the most talented employees around, and the start of some really great customer relationships. We haven't made any sales yet, but we will. We just need the funds to get through all the clinical testing and get government approval for our product. Then these investors will be quite happy that they bought in to our company early!”
Instructions
(a) What is accounting information?
(b) Comment on how Ana's suggestions for what should be reported to prospective investors conforms to the qualitative characteristics of accounting information. Do you think that the things that Ana wants to include in the information for investors will conform to financial reporting guidelines?
EXERCISES: SET B AND CHALLENGE EXERCISES
Visit the book's companion website, at www.wiley.com/college/weygandt, and choose the Student Companion site to access Exercise Set B and Challenge Exercises.
PROBLEMS: SET A
Prepare adjusting entries, post to ledger accounts, and prepare an adjusted trial balance.
(LO 4, 5, 6)
P3-1A Deanna Nardelli started her own consulting firm, Nardelli Consulting, on May 1, 2014. The trial balance at May 31 is as follows.
In addition to those accounts listed on the trial balance, the chart of accounts for Nardelli Consulting also contains the following accounts and account numbers: No. 150 Accumulated Depreciation—Equipment, No. 212 Salaries and Wages Payable, No. 631 Supplies Expense, No. 717 Depreciation Expense, No. 722 Insurance Expense, and No. 732 Utilities Expense.
Other data:
1. $900 of supplies have been used during the month.
2. Utilities expense incurred but not paid on May 31, 2014, $250.
3. The insurance policy is for 2 years.
4. $400 of the balance in the unearned service revenue account remains unearned at the end of the month.
5. May 31 is a Wednesday, and employees are paid on Fridays. Nardelli Consulting has two employees, who are paid $900 each for a 5-day work week.
6. The office furniture has a 5-year life with no salvage value. It is being depreciated at $190 per month for 60 months.
7. Invoices representing $1,700 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. Use J4 as the page number for your journal.
(b) Post the adjusting entries to the ledger accounts. Enter the totals from the trial balance as beginning account balances and place a check mark in the posting reference column.
(c) Prepare an adjusted trial balance at May 31, 2014.
(c) Adj. trial balance $34,920
Prepare adjusting entries, post, and prepare adjusted trial balance and financial statements.
(LO 4, 5, 6)
P3-2A The Skyline Motel opened for business on May 1, 2014. Its trial balance before adjustment on May 31 is as follows.
In addition to those accounts listed on the trial balance, the chart of accounts for Skyline Motel also contains the following accounts and account numbers: No. 142 Accumulated Depreciation—Buildings, No. 150 Accumulated Depreciation—Equipment, No. 212 Salaries and Wages Payable, No. 230 Interest Payable, No. 619 Depreciation Expense, No. 631 Supplies Expense, No. 718 Interest Expense, and No. 722 Insurance Expense.
Other data:
1. Prepaid insurance is a 1-year policy starting May 1, 2014.
2. A count of supplies shows $750 of unused supplies on May 31.
3. Annual depreciation is $3,000 on the buildings and $1,500 on equipment.
4. The mortgage interest rate is 12%. (The mortgage was taken out on May 1.)
5. Two-thirds of the unearned rent revenue has been earned.
6. Salaries of $750 are accrued and unpaid at May 31.
(c) Adj. trial balance $101,305
(d) Net income $4,645 Ending capital balance $46,025 Total assets $93,075
Instructions
(a) Journalize the adjusting entries on May 31.
(b) Prepare a ledger using the three-column form of account. Enter the trial balance amounts and post the adjusting entries. (Use J1 as the posting reference.)
(c) Prepare an adjusted trial balance on May 31.
(d) Prepare an income statement and an owner's equity statement for the month of May and a balance sheet at May 31.
Prepare adjusting entries and financial statements.
(LO 4, 5, 6)
P3-3A Everett Co. was organized on July 1, 2014. Quarterly financial statements are prepared. The unadjusted and adjusted trial balances as of September 30 are shown below.
(b) Net income $4,575 Ending capital $24,975 Total assets $39,350
Prepare adjusting entries.
(LO 4, 5)
1. Insurance expense $4,890
2. Rent revenue $84,000
Instructions
(a) Journalize the adjusting entries that were made.
(b) Prepare an income statement and an owner's equity statement for the 3 months ending September 30 and a balance sheet at September 30.
(c) If the note bears interest at 12%, how many months has it been outstanding?
P3-4A A review of the ledger of Carmel Company at December 31, 2014, produces the following data pertaining to the preparation of annual adjusting entries.
1. Prepaid Insurance $10,440. The company has separate insurance policies on its buildings and its motor vehicles. Policy B4564 on the building was purchased on April 1, 2013, for $7,920. The policy has a term of 3 years. Policy A2958 on the vehicles was purchased on January 1, 2014, for $4,500. This policy has a term of 2 years.
2. Unearned Rent Revenue $429,000. The company began subleasing office space in its new building on November 1. At December 31, the company had the following rental contracts that are paid in full for the entire term of the lease.
3. Notes Payable $120,000. This balance consists of a note for 9 months at an annual interest rate of 9%, dated November 1.
4. Salaries and Wages Payable $0. There are eight salaried employees. Salaries are paid every Friday for the current week. Five employees receive a salary of $700 each per week, and three employees earn $500 each per week. Assume December 31 is a Tuesday. Employees do not work weekends. All employees worked the last 2 days of December.
3. Interest expense $1,800
4. Salaries and wages expense $2,000
Instructions
Prepare the adjusting entries at December 31, 2014.
Journalize transactions and follow through accounting cycle to preparation of financial statements.
(LO 4, 5, 6)
P3-5A On November 1, 2014, the account balances of Schilling Equipment Repair were as follows.
During November, the following summary transactions were completed.
| Nov. | 8 | Paid $1,700 for salaries due employees, of which $700 is for October salaries. |
| 10 | Received $3,420 cash from customers on account. | |
| 12 | Received $3,100 cash for services performed in November. | |
| 15 | Purchased equipment on account $2,000. | |
| 17 | Purchased supplies on account $700. | |
| 20 | Paid creditors on account $2,700. | |
| 22 | Paid November rent $400. | |
| 25 | Paid salaries $1,700. | |
| 27 | Performed services on account and billed customers for services provided $1,900. | |
| 29 | Received $600 from customers for future service. |
Adjustment data consist of:
1. Supplies on hand $1,400.
2. Accrued salaries payable $350.
3. Depreciation for the month is $200.
4. Services related to unearned service revenue of $1,250 were performed.
(d) Trial balance $25,350
(f) Adj. trial balance $25,900
(g) Net income $1,500; Ending capital $15,450 Total assets $18,950
Instructions
(a) Enter the November 1 balances in the ledger accounts.
(b) Journalize the November transactions.
(c) Post to the ledger accounts. Use J1 for the posting reference. Use the following additional accounts: No. 407 Service Revenue, No. 615 Depreciation Expense, No. 631 Supplies Expense, No. 726 Salaries and Wages Expense, and No. 729 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 an owner's equity statement for November and a balance sheet at November 30.
Prepare adjusting entries, adjusted trial balance, and financial statements using appendix.
(LO 4, 5, 6, 7)
*P3-6A Sommer Graphics Company was organized on January 1, 2014, by Krystal Sommer. At the end of the first 6 months of operations, the trial balance contained the accounts shown below.
Analysis reveals the following additional data.
1. The $3,700 balance in Supplies Expense represents supplies purchased in January. At June 30, $1,500 of supplies are on hand.
2. The note payable was issued on February 1. It is a 9%, 6-month note.
3. The balance in Insurance Expense is the premium on a one-year policy, dated March 1, 2014.
4. Service revenues are credited to revenue when received. At June 30, services revenue of $1,300 are unearned.
5. Revenue for services performed but unrecorded at June 30 totals $2,000.
6. Depreciation is $2,250 per year.
(b) Adj. trial balance $112,975
(c) Net income $18,725 Ending capital $40,725 Total assets $71,775
Instructions
(a) Journalize the adjusting entries at June 30. (Assume adjustments are recorded every 6 months.)
(b) Prepare an adjusted trial balance.
(c) Prepare an income statement and owner's equity statement for the 6 months ended June 30 and a balance sheet at June 30.
PROBLEMS: SET B
Prepare adjusting entries, post to ledger accounts, and prepare adjusted trial balance.
(LO 4, 5, 6)
P3-1B Jason Elsner started his own consulting firm, Elsner Company, on June 1, 2014. The trial balance at June 30 is shown below.
In addition to those accounts listed on the trial balance, the chart of accounts for Elsner Company also contains the following accounts and account numbers: No. 158 Accumulated Depreciation—Equipment, No. 212 Salaries and Wages Payable, No. 631 Supplies Expense, No. 711 Depreciation Expense, No. 722 Insurance Expense, and No. 732 Utilities Expense.
Other data:
1. Supplies on hand at June 30 are $750.
2. A utility bill for $150 has not been recorded and will not be paid until next month.
3. The insurance policy is for a year.
4. $2,800 of unearned service revenue is recognized for services performed during the month.
5. Salaries of $1,900 are accrued at June 30.
6. The equipment has a 5-year life with no salvage value. It is being depreciated at $250 per month for 60 months.
7. Invoices representing $1,200 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. Use J3 as the page number for your journal.
(b) Post the adjusting entries to the ledger accounts. Enter the totals from the trial balance as beginning account balances and place a check mark in the posting reference column.
(c) Prepare an adjusted trial balance at June 30, 2014.
(c) Adj. trial balance $41,650
Prepare adjusting entries, post, and prepare adjusted trial balance and financial statements.
(LO 4, 5, 6)
P3-2B Maquoketa River Resort opened for business on June 1 with eight air-conditioned units. Its trial balance before adjustment on August 31 is as follows.
In addition to those accounts listed on the trial balance, the chart of accounts for Maquoketa River Resort also contains the following accounts and account numbers: No. 112 Accounts Receivable, No. 144 Accumulated Depreciation—Buildings, No. 150 Accumulated Depreciation—Equipment, No. 212 Salaries and Wages Payable, No. 230 Interest Payable, No. 620 Depreciation Expense, No. 631 Supplies Expense, No. 718 Interest Expense, and No. 722 Insurance Expense.
Other data:
1. Insurance expires at the rate of $300 per month.
2. A count on August 31 shows $800 of supplies on hand.
3. Annual depreciation is $6,000 on buildings and $2,400 on equipment.
4. Unearned rent revenue of $4,800 was earned prior to August 31.
5. Salaries of $400 were unpaid at August 31.
6. Rentals of $4,000 were due from tenants at August 31. (Use Accounts Receivable.)
7. The mortgage interest rate is 9% per year. (The mortgage was taken out on August 1.)
(c) Adj. trial balance $281,000
(d) Net income $18,300 Ending capital balance $113,300
Total assets $203,400
Instructions
(a) Journalize the adjusting entries on August 31 for the 3-month period June 1–August 31.
(b) Prepare a ledger using the three-column form of account. Enter the trial balance amounts and post the adjusting entries. (Use J1 as the posting reference.)
(c) Prepare an adjusted trial balance on August 31.
(d) Prepare an income statement and an owner's equity statement for the 3 months ending August 31 and a balance sheet as of August 31.
Prepare adjusting entries and financial statements.
(LO 4, 5, 6)
P3-3B Delgado Advertising Agency was founded by Maria Delgado in January of 2013. Presented below are both the adjusted and unadjusted trial balances as of December 31, 2014.
(b) Net income $34,150 Ending capital $47,650 Total assets $65,800
(c) (1) 6%
(2) $2,500
Instructions
(a) Journalize the annual adjusting entries that were made.
(b) Prepare an income statement and an owner's equity statement for the year ending December 31, 2014, and a balance sheet at December 31.
(c) Answer the following questions.
(1) If the note has been outstanding 6 months, what is the annual interest rate on that note?
(2) If the company paid $12,500 in salaries in 2014, what was the balance in Salaries and Wages Payable on December 31, 2013?
Preparing adjusting entries.
(LO 4, 5)
1. Salaries and wages expense $2,640
P3-4B A review of the ledger of Almquist Company at December 31, 2014, 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. Five employees receive a salary of $900 each per week, and three employees earn $700 each per week. Assume December 31 is a Tuesday. Employees do not work weekends. All employees worked the last 2 days of December.
2. Rent revenue $84,000
2. Unearned Rent Revenue $354,000. The company began subleasing office space in its new building on November 1. At December 31, the company had the following rental contracts that are paid in full for the entire term of the lease.
3. Advertising expense $5,200
3. Prepaid Advertising $15,600. 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.
The first advertisement runs in the month in which the contract is signed.
4. Notes Payable $120,000. This balance consists of a note for one year at an annual interest rate of 9%, dated June 1.
4. Interest expense $6,300
Instructions
Prepare the adjusting entries at December 31, 2014. (Show all computations.)
Journalize transactions and follow through accounting cycle to preparation of financial statements.
(LO 4, 5, 6)
P3-5B On September 1, 2014, the account balances of Percy Equipment Repair were as follows.
During September, the following summary transactions were completed.
| Sept. | 8 | Paid $1,400 for salaries due employees, of which $900 is for September. |
| 10 | Received $1,200 cash from customers on account. | |
| 12 | Received $3,400 cash for services performed in September. | |
| 15 | Purchased store equipment on account $3,000. | |
| 17 | Purchased supplies on account $1,200. | |
| 20 | Paid creditors $4,500 on account. | |
| 22 | Paid September rent $500. | |
| 25 | Paid salaries $1,250. | |
| 27 | Performed services on account and billed customers $2,100 for these services. | |
| 29 | Received $650 from customers for future service. |
Adjustment data consist of:
2. Accrued salaries payable $300.
3. Depreciation is $100 per month.
4. Services related to unearned service revenue of $1,450 were performed.
(d) Trial balance $30,750
(f) Adj. trial balance $31,150
(g) Net income $2,000 Ending capital $20,600 Total assets $24,600
Instructions
(a) Enter the September 1 balances in the ledger accounts.
(b) Journalize the September transactions.
(c) Post to the ledger accounts. Use J1 for the posting reference. Use the following additional accounts: No. 407 Service Revenue, No. 615 Depreciation Expense, No. 631 Supplies Expense, No. 726 Salaries and Wages Expense, and No. 729 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 an owner's equity statement for September and a balance sheet at September 30.
PROBLEMS: SET C
Visit the book's companion website, at www.wiley.com/college/weygandt, 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 and 2. Use the information from the previous chapters and follow the instructions below using the general ledger accounts you have already prepared.)
CCC3 It is the end of November and Natalie has been in touch with her grandmother. Her grandmother asked Natalie how well things went in her first month of business. Natalie, too, would like to know if she has been profitable or not during November. Natalie realizes that in order to determine Cookie Creations’ income, she must first make adjustments.
Natalie puts together the following additional information.
1. A count reveals that $35 of baking supplies were used during November.
2. Natalie estimates that all of her baking equipment will have a useful life of 5 years or 60 months. (Assume Natalie decides to record a full month's worth of depreciation, regardless of when the equipment was obtained by the business.)
3. Natalie's grandmother has decided to charge interest of 6% on the note payable extended on November 16. The loan plus interest is to be repaid in 24 months. (Assume that half a month of interest accrued during November.)
4. On November 30, a friend of Natalie's asks her to teach a class at the neighborhood school. Natalie agrees and teaches a group of 35 first-grade students how to make gingerbread cookies. The next day, Natalie prepares an invoice for $300 and leaves it with the school principal. The principal says that he will pass the invoice along to the head office, and it will be paid sometime in December.
5. Natalie receives a utilities bill for $45. The bill is for utilities consumed by Natalie's business during November and is due December 15.
Instructions
Using the information that you have gathered through Chapter 2, and based on the new information above, do the following.
(a) Prepare and post the adjusting journal entries.
(b) Prepare an adjusted trial balance.
(c) Using the adjusted trial balance, calculate Cookie Creations’ net income or net loss for the month of November. Do not prepare an income statement.
Financial Reporting and Analysis
Financial Reporting Problem: Apple Inc.
BYP3-1 The financial statements of Apple Inc. are presented in Appendix A at the end of this textbook. Instructions for accessing and using the company's complete annual report, including the notes to the financial statements, are also provided in Appendix A.
Instructions
(a) Using the consolidated financial statements and related information, identify items that may result in adjusting entries for prepayments.
(b) Using the consolidated financial statements and related information, identify items that may result in adjusting entries for accruals.
(c) What has been the trend since 2009 for net income?
Comparative Analysis Problem:
PepsiCo, Inc. vs. The Coca-Cola Company
BYP3-2 PepsiCo's financial statements are presented in Appendix B. Financial statements for The Coca-Cola Company are presented in Appendix C. Instructions for accessing and using the complete annual reports of PepsiCo and Coca-Cola, including the notes to the financial statements, are also provided in Appendices B and C, respectively.
Instructions
Based on information contained in these financial statements, determine the following for each company.
(a) Net increase (decrease) in property, plant, and equipment (net) from 2010 to 2011.
(b) Increase (decrease) in selling, general, and administrative expenses from 2010 to 2011.
(c) Increase (decrease) in long-term debt (obligations) from 2010 to 2011.
(d) Increase (decrease) in net income from 2010 to 2011.
(e) Increase (decrease) in cash and cash equivalents from 2010 to 2011.
Comparative Analysis Problem:
Amazon.com, Inc. vs. Wal-Mart Stores, Inc.
BYP3-3 Amazon.com, Inc.'s financial statements are presented in Appendix D. Financial statements for Wal-Mart Stores, Inc. are presented in Appendix E. Instructions for accessing and using the complete annual reports of Amazon and Wal-Mart, including the notes to the financial statements, are also provided in Appendices D and E, respectively.
Instructions
Based on information contained in these financial statements, determine the following for each company.
1. (a) Increase (decrease) in interest expense from 2010 to 2011.
(b) Increase (decrease) in net income from 2010 to 2011.
(c) Increase (decrease) in cash flow from operations from 2010 to 2011.
2. Cash flow from operations and net income for each company is different. What are some possible reasons for these differences?
Real-World Focus
BYP3-4 No financial decision-maker should ever rely solely on the financial information reported in the annual report to make decisions. It is important to keep abreast of financial news. This activity demonstrates how to search for financial news on the Internet.
Address: http://biz.yahoo.com/i, or go to www.wiley.com/college/weygandt
Steps:
1. Type in either Wal-Mart, Target Corp., or Kmart.
2. Choose News.
3. Select an article that sounds interesting to you and that would be relevant to an investor in these companies.
Instructions
(a) What was the source of the article (e.g., Reuters, Businesswire, Prnewswire)?
(b) Assume that you are a personal financial planner and that one of your clients owns stock in the company. Write a brief memo to your client summarizing the article and explaining the implications of the article for their investment.
BYP3-5 The July 6, 2011, edition of the Wall Street Journal Online includes an article by Michael Rapoport entitled “U.S. Firms Clash Over Accounting Rules.” The article discusses why some U.S. companies favored adoption of International Financial Reporting Standards (IFRS) while other companies opposed it.
Instructions
Read the article and answer the following questions.
(a) The articles says that the switch to IFRS tends to be favored by “larger companies, big accounting firms, and rule makers.” What reasons are given for favoring the switch?
(b) What two reasons are given by many smaller companies that oppose the switch?
(c) What criticism of IFRS is raised with regard to regulated companies?
(d) Explain what is meant by “condorsement.”
Critical Thinking
Decision-Making Across the Organization
BYP3-6 Happy Camper Park was organized on April 1, 2013, by Barbara Evans. Barbara is a good manager but a poor accountant. From the trial balance prepared by a part-time bookkeeper, Barbara prepared the following income statement for the quarter that ended March 31, 2014.
Barbara thought 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 above in the income statement, the ledger contains the following additional selected balances at March 31, 2014.
| Supplies | $ 6,200 |
| Prepaid Insurance | 7,200 |
| Notes Payable | 12,000 |
You then make inquiries and discover the following.
1. Rent revenues include advanced rentals for summer occupancy $15,000.
2. There were $1,700 of supplies on hand at March 31.
3. Prepaid insurance resulted from the payment of a one-year policy on January 1, 2014.
4. The mail on April 1, 2014, brought the following bills: advertising for week of March 24, $110; repairs made March 10, $260; and utilities, $180.
5. There are four employees, who receive wages totaling $300 per day. At March 31, 2 days’ salaries and wages have been incurred but not paid.
6. The note payable is a 3-month, 10% note dated January 1, 2014.
Instructions
With the class divided into groups, answer the following.
(a) Prepare a correct income statement for the quarter ended March 31, 2014.
(b) Explain to Barbara the generally accepted accounting principles that she did not recognize in preparing her income statement and their effect on her results.
Communication Activity
BYP3-7 In reviewing the accounts of Gloria Jean Co. at the end of the year, you discover that adjusting entries have not been made.
Instructions
Write a memo to Gloria Jean Hall, the owner of Gloria Jean Co., that explains the following: the nature and purpose of adjusting entries, why adjusting entries are needed, and the types of adjusting entries that may be made.
Ethics Case
BYP3-8 Kellner Company is a pesticide manufacturer. Its sales declined greatly this year due to the passage of legislation outlawing the sale of several of Kellner's chemical pesticides. In the coming year, Kellner will have environmentally safe and competitive chemicals to replace these discontinued products. Sales in the next year are expected to greatly exceed any prior year's. The decline in sales and profits appears to be a one-year aberration. But even so, the company president fears a large dip in the current year's profits. He believes that such a dip could cause a significant drop in the market price of Kellner's stock and make the company a takeover target.
To avoid this possibility, the company president calls in Melissa Ray, controller, to discuss this period's year-end adjusting entries. He urges her to accrue every possible revenue and to defer as many expenses as possible. He says to Melissa, “We need the revenues this year, and next year can easily absorb expenses deferred from this year. We can't let our stock price be hammered down!” Melissa 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. Melissa 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 (1) the president's request and (2) Melissa dating the adjusting entries December 31?
(c) Can Melissa accrue revenues and defer expenses and still be ethical?
All About You
BYP3-9 Companies must report or disclose in their financial statement information about all liabilities, including potential liabilities related to environmental cleanup. There are many situations in which you will be asked to provide personal financial information about your assets, liabilities, revenue, and expenses. Sometimes you will face difficult decisions regarding what to disclose and how to disclose it.
Instructions
Suppose that you are putting together a loan application to purchase a home. Based on your income and assets, you qualify for the mortgage loan, but just barely. How would you address each of the following situations in reporting your financial position for the loan application? Provide responses for each of the following situations.
(a) You signed a guarantee for a bank loan that a friend took out for $20,000. If your friend doesn't pay, you will have to pay. Your friend has made all of the payments so far, and it appears he will be able to pay in the future.
(b) You were involved in an auto accident in which you were at fault. There is the possibility that you may have to pay as much as $50,000 as part of a settlement. The issue will not be resolved before the bank processes your mortgage request.
(c) The company for which you work isn't doing very well, and it has recently laid off employees. You are still employed, but it is quite possible that you will lose your job in the next few months.
Considering People, Planet, and Profit
BYP3-10 Many companies have potential pollution or environmental-disposal problems—not only for electronic gadgets, but also for the lead paint or asbestos they sold. How do we fit these issues into the accounting equation? Are these costs and related liabilities that companies should report?
YES: As more states impose laws holding companies responsible, and as more courts levy pollution-related fines, it becomes increasingly likely that companies will have to pay large amounts in the future.
NO: The amounts still are too difficult to estimate. Putting inaccurate estimates on the financial statements reduces their usefulness. Instead, why not charge the costs later, when the actual environmental cleanup or disposal occurs, at which time the company knows the actual cost?
Instructions
Write a response indicating your position regarding this situation. Provide support for your view.
FASB Codification Activity
BYP3-11 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 Chapter Questions
Answers to Insight and Accounting Across the Organization Questions
p. 102 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, the penalties for such behavior are now much more severe.
p. 109 Turning Gift Cards into Revenue Q: Suppose that Robert Jones purchases a $100 gift card at Best Buy on December 24, 2013, and gives it to his wife, Mary Jones, on December 25, 2013. On January 3, 2014, 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 the performance obligation is satisfied. In this case, revenue results when Best Buy provides the goods. Thus, when Best Buy receives cash in exchange for the gift card on December 24, 2013, it should recognize a liability, Unearned Sales Revenue, for $100. On January 3, 2014, when Mary Jones exchanges the card for merchandise, Best Buy should recognize revenue and eliminate $100 from the balance in the Unearned Sales Revenue account.
p. 114 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.
p. 116 Got Junk? Q: What accounting issue might this cause for companies? A: The balance sheet should provide a fair representation of what a company owns and what it owes. If significant obligations of the company are not reported on the balance sheet, the company's net worth (its equity) will be overstated. While it is true that it is not possible to estimate the exact amount of future environmental cleanup costs, it is becoming clear that companies will be held accountable. Therefore, it seems reasonable to accrue for environmental costs. Recognition of these liabilities provides a more accurate picture of the company's financial position. It also has the potential to improve the environment. As companies are forced to report these amounts on their financial statements, they will start to look for more effective and efficient means to reduce toxic waste and therefore reduce their costs.
Answers to Self-Test Questions
1. a 2. c 3. d 4. a 5. d 6. d 7. c ($1,350 – $600) 8. c 9. a 10. c 11. a 12. b 13. b 14. c *15. a *16. c *17. c
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 that will enable companies to better use the same principles to record transactions consistently over time.
LEARNING OBJECTIVE 9
Compare the procedures for adjusting entries under GAAP and IFRS.
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 time period assumption.
- IFRS requires that companies present a complete set of financial statements, including comparative information, annually.
- The general revenue recognition principle required by GAAP that is used in this textbook is similar to that used under IFRS.
- 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.
- Under IFRS, revaluation (using fair value) 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 under IFRS 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 under IFRS 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 is in contrast to GAAP, which defines each separately.
Looking to the Future
The IASB and FASB are completing a joint project on revenue recognition. The purpose of this project is to develop comprehensive guidance on when to recognize revenue. 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 Practice
IFRS Self-Test Questions
1. IFRS:
(a) uses accrual accounting.
(b) uses cash-basis accounting.
(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 time period 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 by the FASB and IASB:
(a) revenue recognition places more emphasis on when the performance obligation is satisfied.
(b) revenue recognition places more emphasis on when revenue is realized.
(c) revenue recognition places more emphasis on when expenses are incurred.
(d) revenue is no longer 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, companies do not engage in the adjusting process.
(d) Under IFRS, revenue recognition fraud is a major issue.
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) has been eliminated as a result of the IASB/FASB joint project on revenue recognition.
(d) is not consistent with the IASB conceptual framework.
IFRS Exercises
IFRS3-1 Compare and contrast the rules regarding revenue recognition under IFRS versus GAAP.
IFRS3-2 Under IFRS, do the definitions of revenues and expenses include gains and losses? Explain.
International Financial Reporting Problem: Zetar plc
IFRS3-3 The financial statements of Zetar plc are presented in Appendix F. Instructions for accessing and using the company's complete annual report, including the notes to its financial statements, are also provided in Appendix F.
Instructions
Visit Zetar's corporate website and answer the following questions from Zetar's 2011 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. a 4. c 5. b
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1The definition for the revenue recognition principle is based on the revised exposure draft issued by the FASB.
2This example focuses only on the alternative treatment of unearned revenues. For simplicity, we have ignored the entries to Service Revenue pertaining to the immediate recognition of revenue ($10,000) and the adjusting entry for accrued revenue ($200).