Chapter 3: Adjusting the Accounts

Learning ObjectivesAfter 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.

4 Identify the major types of adjusting entries.

5 Prepare adjusting entries for deferrals.

6 Prepare adjusting entries for accruals.

7 Describe the nature and purpose of an adjusted

trial balance.

Feature Story

What Was Your Profi t?The accuracy of the fi nancial reporting

system depends on answers to a few

fundamental questions: At what point

has revenue been recognized? When

have expenses really been incurred?

Unfortunately, all too often companies

overstate their revenues. For example,

during the dot-com boom, most

dot-coms earned a large percentage of

their revenue from selling advertising

space on their websites. To boost

reported revenue, some dot-coms

began swapping website ad space.

Company A would put an ad for its

website on company B’s website, and

company B would put an ad for its

website on company A’s website.

No money changed hands, but each

company recorded revenue (for the

value of the space that it gave the

other company on its site). This

practice did little to boost net income,

and it resulted in no additional cash

fl ow—but it did boost reported

revenue. Regulators eventually put

an end to this misleading practice.

Another type of transgression results

from companies recording revenues or

expenses in the wrong year. In fact,

shifting revenues and expenses is one

of the most common abuses of

fi nancial accounting. For example,

here is a sample of British companies

that have recently disclosed issues

regarding revenue recognition: the

96

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The Navigator✔

Adjusting the Accounts

✔ The Navigator

Chapter 3

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Nigerian unit of candy company Cadbury (GBR); vehicle and

accident management company Helphire (GBR), which

appeared to overstate the amount

it was due in reimbursement from

insurance companies; and Alterian

(GBR), a software fi rm that specializes

in social media, email, and web

content management and analytics.

Perhaps one of the most unusual

cases of reporting expenses in the

wrong period was recently revealed

by Olympus Corporation (JPN). The

company admitted that it had covered

up investment losses for more than a decade. It then recently

tried to eliminate the losses from the books through a

fraudulent process of overstating the price of some acquired

assets and then writing down those assets in subsequent

adjusting entries.

Unfortunately, revelations such as these have become all

too common in the corporate world. It is no wonder that

a survey of affluent investors

reported that 85% of respondents

believed that there should be

tighter regulation of financial disclo-

sures; 66% said they did not trust

the management of publicly traded

companies.

Why did so many companies violate

basic fi nancial reporting rules and

sound ethics? Many speculate that as

share prices climbed, executives were

under increasing pressure to meet higher and higher earnings

expectations. If actual results weren’t as good as hoped for,

some gave in to temptation and “adjusted” their numbers to

meet market expectations.

✔ The Navigator

97

In Chapter 1, you learned a neat little formula: Net income 5 Revenues 2 Expenses. In Chapter 2, you learned some rules for recording revenue and expense transactions. Guess what? Things are not reallythat nice and neat. In fact, it is often diffi cult 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.

Preview of Chapter 3

• Fiscal and calendar years• Accrual- vs. cash-basis

accounting• Recognizing revenues and

expenses

Timing Issues

• Types of adjusting entries• Adjusting entries for deferrals• Adjusting entries for accruals• Summary of basic relationships

The Basics of Adjusting Entries

• Preparing the adjusted trialbalance

• Preparing fi nancial statements

The Adjusted Trial Balanceand Financial Statements

✔ The Navigator

ADJUSTING THE ACCOUNTS

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98 3 Adjusting the Accounts

We would need no adjustments if we could wait to prepare fi nancial statements until a company ended its operations. At that point, we could easily determine its fi nal statement of fi nancial position 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 fi nancial statements, and taxing agencies require all businesses to fi le annual tax returns. Therefore, accountants divide the economic life of a business into artifi cial 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 Cathay Pacifi c (HKG) fi ve years ago are still in use today. We must determine the relevance of each business transaction to specifi c accounting periods. (How much of an airplane’s original cost contrib-uted to this period’s operations?)

Fiscal and Calendar Years

Both small and large companies prepare fi nancial statements periodically in order to assess their fi nancial 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 fi nancial statements.

An accounting time period that is one year in length is a fi scal year. A fi scal year usually begins with the fi rst 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 Decem-ber 31) as their accounting period. Some do not. Companies whose fi scal year differs from the calendar year include Vodafone Group (GBR), March 31, and Walt Disney Productions (USA), September 30. Sometimes a company’s year-end will vary from year to year. For example, JJB Sports’ (GBR) fi scal year ends on the Sunday that falls closest before January 31, resulting in accounting periods of either 52 or 53 weeks.

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 finan-cial 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 actually perform the 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 fi nancial statements. It fails to re-cord revenue for a company that has provided 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 International Financial Re-porting Standards (IFRS).

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.

Explain the time period assumption.

LEARNING OBJECTIVE 1

Time PeriodAssumption

Year 1 Year 10

Year 6

Alternative TerminologyThe time period assumption is also called the periodicity assumption.

Explain the accrual basis of accounting.


Timing Issues


Timing Issues 99

Recognizing Revenues and Expenses

It can be diffi cult to determine when to report revenues and expenses. The revenue recognition principle and the expense recognition principle help in this task.

REVENUE RECOGNITION PRINCIPLEWhen 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 satisfi ed.1 To illustrate, assume that Dave’s Dry Cleaning cleans cloth-ing on June 30, but customers do not claim and pay for their clothes until the fi rst week of July. Dave’s should record revenue in June when it performed the service (satisfi es the performance obligation) rather than in July when it received the cash. At June 30, Dave’s would report a receivable on its statement of fi nancial position and revenue in its income statement for the service performed.

EXPENSE RECOGNITION PRINCIPLEAccountants 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 statement of fi nancial position.

This practice of expense recognition is referred to as the expense recogni-tion 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.

Helpful HintRecognize means to record or to report.

Revenue should be recog-nized in the accountingperiod in which services

are performed.

Revenue Recognition

Customerrequests services

Services performed

Cashreceived

MatchingRevenues

Expenses

Advertising

Delivery

Utilities

Expense Recognition

Revenue and ExpenseRecognition

In accordance with InternationalFinancial Reporting Standards

(IFRS).

Expense Recognition Principle

Match expenses with revenues in theperiod when the company makes

efforts to generate those revenues.

Time Period Assumption

Economic life of businesscan be divided into

artificial time periods.

Revenue RecognitionPrinciple

Recognize revenue in the accounting period in which the performance

obligation is satisfied.

Illustration 3-1IFRS relationships in revenue and expense recognition

1The definition for the revenue recognition principle is based on the revised exposure draft issued by the IASB and FASB.



Timing Concepts

> DO IT!

Several timing concepts are discussed on pages 98–99. 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.

2. ____Calendar year.

3. ____Time period assumption.

4. ____Expense recognition principle.

Solution

Action Plan✔ Review the glossary

terms identifi ed on pages 98–99.

✔ Study carefully the revenue recognition principle, the expense recognition principle, and the time period assumption.

1. f 2. e 3. c 4. b

Related exercise material: E3-1, E3-2, E3-3, and DO IT! 3-1.

✔ The Navigator

(a) Monthly and quarterly time periods.(b) Efforts (expenses) should be matched

with results (revenues).(c) Accountants divide the economic life of

a business into artifi cial time periods.(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.

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 fi rst pulling together of the transaction data—may not contain up-to-date and complete data. This is true for several reasons:

Explain the reasons for adjusting entries.


The Basics of Adjusting Entries

ETHICS INSIGHTCooking 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 (USA) 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 (USA) was accused of backdating sales—that is, saying that a sale that occurred at the beginning of one quarter occurred at the end of the previous quarter in order to achieve the previous quarter’s sales targets.

?What motivates sales executives and fi nance and accounting executives to participate in activities that result in inaccurate reporting of revenues? (See page 152.)

© Dan Chippendale/iStockphoto


The Basics of Adjusting Entries 101

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 trans-actions. 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 fi nancial statements. The company analyzes each account in the trial balance to deter-mine whether it is complete and up to date for fi nancial statement purposes. Every adjusting entry will include one income statement account and one statement of fi nancial position account.

Types of Adjusting Entries

Adjusting entries are classifi ed as either deferrals or accruals. As Illustration 3-2 shows, each of these classes has two subcategories.

Identify the major types of adjusting entries.


Illustration 3-2Categories of adjusting entriesDeferrals:

1. Prepaid expenses: Expenses paid in cash before they are used or consumed.2. Unearned revenues: Cash received before services are performed.

Accruals:

1. Accrued revenues: Revenues for services performed but not yet received in cash or recorded.

2. Accrued expenses: Expenses incurred but not yet paid in cash or recorded.

Subsequent sections give examples of each type of adjustment. Each example is based on the October 31 trial balance of Pioneer Advertising Agency Inc. from Chapter 2, reproduced in Illustration 3-3.

Pioneer Advertising Agency Inc.Trial Balance

October 31, 2014

Debit Credit

Cash 15,200Supplies 2,500Prepaid Insurance 600Equipment 5,000Notes Payable 5,000Accounts Payable 2,500Unearned Service Revenue 1,200Share Capital—Ordinary 10,000Retained Earnings –0–Dividends 500Service Revenue 10,000Salaries and Wages Expense 4,000Rent Expense 900

28,700 28,700

Illustration 3-3Trial balance



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 costs or revenues that are recognized at a date later than the point when cash was originally exchanged. Companies make adjusting entries for deferrals to record the portion of the deferred item that was incurred as an expense or recognized as revenue during the current accounting period. The two types of deferrals are prepaid expenses and unearned revenues.

PREPAID EXPENSESWhen companies record payments of expenses that will benefi t 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 benefi t 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 fi nancial 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.

Prepare adjusting entries for deferrals.


Prepaid Expenses

Asset

CreditAdjustingEntry (–)

UnadjustedBalance

Expense

DebitAdjustingEntry (+)

Illustration 3-4Adjusting entries for prepaid expenses

Let’s look in more detail at some specifi c 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, com-panies recognize supplies expense at the end of the accounting period. At the end of the accounting period, the company counts the remaining supplies. The difference between the unadjusted balance in the Supplies (asset) account and the actual cost of supplies on hand represents the supplies used (an expense) for that period (page 103).

Recall from Chapter 2 that Pioneer Advertising Agency Inc. purchased sup-plies costing 2,500 on October 5. Pioneer recorded the purchase by increasing

Supplies used;record supplies expense

Supplies purchased;record asset

Oct. 31

Oct. 5

Supplies

PioneerAdvertising

Agency



(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 2 1,000). This use of supplies decreases an asset, Supplies. It also decreases equity by increasing an expense account, Supplies Expense. This is shown in Illustration 3-5.

Debit–CreditAnalysis

JournalEntry

Posting

BasicAnalysis

EquationAnalysis

Oct. 5 2,500

Oct. 31 Bal. 1,000

Oct. 31 Adj. 1,500

Supplies 126 631

Oct. 31 Adj. 1,500

Oct. 31 Bal. 1,500

Supplies Expense

Debits increase expenses: debit Supplies Expense 1,500. Credits decrease assets: credit Supplies 1,500.

Oct. 31 Supplies Expense Supplies (To record supplies used)

1,5001,500

The expense Supplies Expense is increased 1,500, and the assetSupplies is decreased 1,500.

Assets

Supplies

– 1,500

=

=

+Liabilities Equity

Supplies Expense

– 1,500

Illustration 3-5Adjustment 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, Sup-plies 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 will be understated and net income overstated by 1,500. Moreover, both as-sets and equity will be overstated by 1,500 on the October 31 statement of fi nancial position.

INSURANCE Companies purchase insurance to protect themselves from losses due to fi re, 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 fi nancial 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 fi re insurance policy. Coverage began on October 1. Pioneer recorded the payment by increas-ing (debiting) Prepaid Insurance. This account shows a balance of 600 in the October 31 trial balance. Insurance of 50 ( 600 4 12) expires each month. The expiration of prepaid insurance decreases an asset, Prepaid Insurance. It also decreases equity by increasing an expense account, Insurance Expense.

As shown in Illustration 3-6 (page 104), 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

Insurance expired;record insurance expense

Insurance purchased;record asset

Oct. 4

Oct. 31

Insurance

Insurance PolicyNov 50

Dec 50

Jan 50

Feb 50

March 50

April 50

May 50

June 50

July 50

Aug 50

Sept 50

1 YEAR 600

Oct 50

1 yearinsurancepolicy 600



expenses are understated by 50 and net income is overstated by 50. Moreover, as the accounting equation shows, both assets and equity will be overstated by

50 on the October 31 statement of fi nancial position.

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 prin-ciple, 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 impor-tant point to understand: Depreciation is an allocation concept, not a valua-tion 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 on the next page, 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 statement of fi nancial position. 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 equity by increasing an expense account, Depreciation Expense.


JournalEntry

BasicAnalysis

EquationAnalysis

Debits increase expenses: debit Insurance Expense 50. Credits decrease assets: credit Prepaid Insurance 50.

Oct. 31 Insurance Expense Prepaid Insurance (To record insurance expired)

5050

The expense Insurance Expense is increased 50, and the assetPrepaid Insurance is decreased 50.

AssetsPrepaid Insurance

� 50

=

=

+Liabilities EquityInsurance Expense

� 50

EquationAnalysis

PostingPrepaid Insurance 130 722Insurance Expense

Oct. 4 600

Oct. 31 Bal. 550

Oct. 31 Adj. 50 Oct. 31 Adj. 50

Oct. 31 Bal. 50

Illustration 3-6Adjustment for insurance

Depreciation recognized;record depreciation expense

Equipment purchased;record asset

Oct. 2

Oct. 31

Depreciation

EquipmentOct 40

Nov 40

Dec 40

Jan 40

Feb 40

March 40

April 40

May 40

June 40

July 40

Aug 40

Sept 40

Depreciation = 480/year

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JournalEntry

Posting

BasicAnalysis

Oct. 31 Adj. 40

Oct. 31 Bal. 40

Accumulated Depreciation—Equipment 711158

Oct. 31 Adj. 40

Oct. 31 Bal. 40

DepreciationExpense

Oct. 2 5,000

Oct. 31 Bal. 5,000

Equipment 157

Debits increase expenses: debit Depreciation Expense 40. Credits increase contra assets: credit AccumulatedDepreciation—Equipment 40.

Oct. 31 Depreciation Expense Accumulated Depreciation—Equipment (To record monthly depreciation)

4040

The expense Depreciation Expense is increased 40, and the contra assetAccumulated Depreciation—Equipment is increased 40.

AssetsAccumulated

Depreciation—Equipment

� 40

=

=

+Liabilities Equity

Depreciation Expense

� 40

EquationAnalysis

Illustration 3-7Adjustment for depreciation

The balance in the Accumulated Depreciation—Equipment account will increase 40 each month, and the balance in Equipment remains 5,000.

Statement Presentation. As indicated, Accumulated Depreciation—Equipment is a contra asset account. It is offset against Equipment on the statement of fi nancial position. The normal balance of a contra asset account is a credit. A theoretical alternative to using a contra asset account would be to decrease (credit) the asset account by the amount of depreciation each period. But using the contra account is preferable for a simple reason: It discloses both the original cost of the equipment and the total cost that has expired to date. Thus, in the statement of fi nancial posi-tion, Pioneer deducts Accumulated Depreciation—Equipment from the related asset account, as shown in Illustration 3-8.

Helpful HintAll contra accounts have increases, decreases, and normal balances opposite to the account to which they relate.

Illustration 3-8Statement of fi nancial position presentation of accumulated depreciation

Equipment 5,000Less: Accumulated depreciation—equipment 40

4,960

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 statement of fi nancial position 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 identifi es the portion of an asset’s cost that expired during the period (in this case, in October). The accounting equation shows that

Alternative TerminologyBook value is also referred to as carrying value.



without this adjusting entry, assets, equity, and net income are overstated by 40 and depreciation expense is understated by 40.

Illustration 3-9 summarizes the accounting for prepaid expenses.

Illustration 3-9Accounting for prepaid expenses

Accounting for Prepaid Expenses

Reason for Accounts Before Adjusting Examples Adjustment Adjustment Entry

Insurance, supplies, Prepaid expenses Assets overstated. Dr. Expensesadvertising, rent, recorded in asset Expenses understated. Cr. Assetsdepreciation accounts have or Contra been used. Asset

UNEARNED REVENUESWhen companies receive cash before services are performed, they record a liability called unearned revenue. 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 Ryanair (IRL), Qatar Airways (QAT), and Delta Airlines (USA), for instance, treat receipts from the sale of tickets as un-earned revenue until the fl ight 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 iden-tical 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 provides 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.

Some service has beenperformed; some revenue

is recorded

Cash is received in advance;liability is recorded

Oct. 2

Oct. 31

Unearned Revenues

Thank youin advance for

your work

I will finish by Dec. 31

1,200

Unearned Revenues

Liability Revenue

CreditAdjustingEntry (+)

DebitAdjustingEntry (–)

UnadjustedBalance

Illustration 3-10Adjusting entries for unearned revenues

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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, and 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 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 are overstated and equity is understated by 400 on the October 31 statement of fi nancial position.

Alternative TerminologyUnearned revenue is sometimes referred to as deferred revenue.


JournalEntry

Posting

BasicAnalysis

Oct. 31 Adj. 400 Oct. 2 1,200

Oct.31 Bal. 800

Oct. 3 10,000 31 Adj. 400

Oct. 31 Bal. 10,400

Unearned Service Revenue 209 Service Revenue 400

Debits decrease liabilities: debit Unearned Service Revenue 400. Credits increase revenues: credit Service Revenue 400.

Oct. 31 Unearned Service Revenue Service Revenue (To record revenue for services performed)

400400

The liability Unearned Service Revenue is decreased 400, and the revenueService Revenue is increased 400.

AssetsUnearned

Service Revenue

= +Liabilities Equity

Service RevenueEquationAnalysis

� 400 � 400

Illustration 3-11Service revenue accounts after adjustment

Illustration 3-12 summarizes the accounting for unearned revenues.

Illustration 3-12Accounting for unearned revenues

Accounting for Unearned Revenues


Rent, magazine Unearned revenues Liabilities overstated. Dr. Liabilitiessubscriptions, recorded in liability Revenues understated. Cr. Revenuescustomer deposits accounts are now for future service recognized as revenue for services performed.



?

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 at stores such as Marks & Spencer plc (GBR) 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?

Source: Robert Berner, “Gift Cards: No Gift to Investors,” BusinessWeek (March 14, 2005), p. 86.

ACCOUNTING ACROSS THE ORGANIZATION

Suppose that Robert Jones purchases a €100 gift card at Carrefour (FRA) 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 Carrefour should recognize revenue and why? (See page 153.)

Adjusting Entries for Deferrals

> DO IT!

The ledger of Zh–u Company on March 31, 2014, includes these selected accounts before adjusting entries are prepared.

Debit Credit

Prepaid Insurance ¥ 3,600,000Supplies 2,800,000Equipment 25,000,000Accumulated Depreciation—Equipment ¥5,000,000Unearned Service Revenue 9,200,000

An analysis of the accounts shows the following.

1. Insurance expires at the rate of ¥100,000 per month.

2. Supplies on hand total ¥800,000.

3. The equipment depreciates ¥200,000 a month.

4. One-half of the unearned service revenue was recognized in March.

Prepare the adjusting entries for the month of March.

Solution

1. Insurance Expense 100,000 Prepaid Insurance 100,000 (To record insurance expired)

2. Supplies Expense 2,000,000 Supplies 2,000,000 (To record supplies used)

3. Depreciation Expense 200,000 Accumulated Depreciation—Equipment 200,000 (To record monthly depreciation)

Action Plan✔ Make adjusting entries

at the end of the period for revenues recognized and expenses incurred in the period.

REUTERS/Toby Melville/NewsCom



Cash is received; receivable is reduced

Revenue and receivableare recorded forunbilled services

Oct. 31

Nov. 10

Accrued Revenues

My feeis 200

Adjusting Entries for Accruals

The second category of adjusting entries is accruals. Prior to an accrual ad-justment, 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 statement of fi nancial position and an income statement account.

ACCRUED REVENUESRevenues 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 or collected, as in the case of commissions and fees. These may be unrecorded because only a portion of the total service has been provided and the clients won’t be billed until the service has been completed.

An adjusting entry records the receivable that exists at the statement of fi nan-cial position date and the revenue for the services performed during the period. Prior to adjustment, both assets and revenues are understated. As shown in Illus-tration 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.

Prepare adjusting entries for accruals.


Helpful HintFor accruals, there may have been no prior entry, and the accounts requiringadjustment may both have zero balances prior toadjustment.

Accrued Revenues

Asset Revenue



Illustration 3-13Adjusting entries for accrued revenues

In October, Pioneer Advertising Agency Inc. recognized 200 for advertising services performed that were not billed to clients on or before October 31. Because these services are not billed, they are not recorded. The accrual of unre-corded service revenue increases an asset account, Accounts Receivable. It also

4. Unearned Service Revenue 4,600,000 Service Revenue 4,600,000 (To record revenue for services performed)

✔ The Navigator

Related exercise material: BE3-3, BE3-4, BE3-5, BE3-6, and DO IT! 3-2.

✔ 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.

Action Plan (cont’d)




JournalEntry

Posting

BasicAnalysis

Oct. 31 Adj. 200

Oct. 31 Bal. 200

Accounts Receivable 112

Debits increase assets: debit Accounts Receivable 200. Credits increase revenues: credit Service Revenue 200.

Oct. 31 Accounts Receivable Service Revenue (To record revenue for services performed)

200200

The asset Accounts Receivable is increased 200, and the revenue ServiceRevenue is increased 200.

Assets = +Liabilities Equity

Service Revenue

� 200

AccountsReceivable

� 200

EquationAnalysis

Oct. 3 10,000 31 400 31 Adj. 200

Oct. 31 Bal. 10,600

Service Revenue 400

Illustration 3-14Adjustment for accrued revenue

Accounting for Accrued Revenues


Interest, rent, Services performed Assets understated. Dr. Assetsservices performed but not yet Revenues understated. Cr. Revenuesbut not collected recorded.

Illustration 3-15Accounting for accrued revenues

Equation analysessummarize the effects of transactions on the three elements of the accounting equation, as well as the effect on cash fl ows.

12002200

Cash Flows1200

A EL5 1

The asset Accounts Receivable shows that clients owe Pioneer 200 at the statement of fi nancial position date. The balance of 10,600 in Service Revenue represents the total revenue for services performed by Pioneer during the month ( 10,000 1 400 1 200). Without the adjusting entry, assets and equity on the statement of fi nancial position 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.

Nov. 10 Cash 200 Accounts Receivable 200 (To record cash collected on account)

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.

ACCRUED EXPENSESExpenses 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.

increases equity by increasing a revenue account, Service Revenue, as shown in Illustration 3-14.



Accrued Expenses

Expense Liability



Illustration 3-16Adjusting entries for accrued expenses

As Illustration 3-18 (page 112) shows, the accrual of interest at October 31 increases a liability account, Interest Payable. It also decreases equity by increas-ing an expense account, Interest Expense.

Interest Expense shows the interest charges for the month of October. Interest Payable shows the amount of interest the company owes at the statement date. 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 equity are overstated.

Companies make adjustments for accrued expenses to record the obligations that exist at the statement of fi nancial position 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.

Let’s look in more detail at some specifi c 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 3 12% 3 3

12), or 50 for one month. Illustra-tion 3-17 shows the formula for computing interest and its application to Pioneer for the month of October.

A report released by Fannie Mae’s (USA) board of directors stated that improper adjusting entries at the mortgage-fi nance company resulted in delayed recognition of expenses caused by interest-rate changes. The motivation for such accounting apparently was the desire to achieve earnings estimates.

Ethics Note

Annual Time in Face Value 3 Interest 3 Terms of 5 Interest of Note Rate One Year

5,000 3 12% 3 112— 5 50

Illustration 3-17Formula for computing interest

Helpful HintIn computing interest, we express the time period as a fraction of a year.



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’ fi rst 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).

October

Adjustment period

Start ofpay period

Payday Payday

S M Tu W Th F S1 2 3 4 5 6

7 8 9 10 11 12 1314 16 17 18 19 2021 22 23 24 25 2728 29 30 31

2615

November

S M Tu W Th F S1 2 3

4 5 6 7 8 1011 13 14 15 16 1718 19 20 21 22 2425 26 27 28

2329 30

129

Illustration 3-19Calendar 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 fi ve-day work week, or 400 per day. Thus, accrued salaries and wages at October 31 are 1,200 ( 400 3 3). This accrual increases a liability, Salaries and Wages Payable. It also decreases equity by increasing an expense account, Salaries and Wages Expense, as shown in Illustration 3-20.

After this adjustment, the balance in Salaries and Wages Expense of 5,200 (13 days 3 400) is the actual salary and wages expense for October. The balance


JournalEntry

Posting

BasicAnalysis

EquationAnalysis

Oct. 31 Adj. 50

Oct. 31 Bal. 50

Oct. 31 Adj. 50

Oct. 31 Bal. 50

Interest Expense 905 Interest Payable 230

Debits increase expenses: debit Interest Expense 50. Credits increase liabilities: credit Interest Payable 50.

Oct. 31 Interest Expense Interest Payable (To record interest on notes payable)

5050

The expense Interest Expense is increased 50, and the liability InterestPayable is increased 50.

Assets

Interest Payable

� 50


Interest Expense

� 50

Illustration 3-18Adjustment for accrued interest




JournalEntry

Posting

BasicAnalysis

EquationAnalysis

Oct. 26 4,000 31 Adj. 1,200

Oct. 31 Bal. 5,200

Oct. 31 Adj. 1,200

Oct. 31 Bal. 1,200

Salaries and Wages Expense 726 Salaries and Wages Payable 212

Debits increase expenses: debit Salaries and Wages Expense 1,200. Credits increase liabilities: credit Salaries and Wages Payable 1,200.

Oct. 31 Salaries and Wages Expense Salaries and Wages Payable (To record accrued salaries and wages)

1,2001,200

The expense Salaries and Wages Expense is increased 1,200, and the liabilityaccount Salaries and Wages Payable is increased 1,200.

Assets

Salaries and Wages Payable

� 1,200


Salaries and Wages Expense

� 1,200

Illustration 3-20Adjustment for accrued salaries and wages

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 liabili-ties 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 3 400). Therefore, Pioneer makes the following entry on November 9.

Nov. 9 Salaries and Wages Payable 1,200 Salaries and Wages Expense 2,800 Cash 4,000 (To record November 9 payroll)

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.

21,200 22,800 Exp24,000

Cash Flows24,000

A EL5 1

Accounting for Accrued Expenses


Interest, rent, Expenses have been Expenses understated. Dr. Expensessalaries incurred but not yet paid Liabilities understated. Cr. Liabilities in cash or recorded.

Illustration 3-21Accounting for accrued expenses



© Nathan Gleave/iStockphoto

Adjusting Entries for Accruals

> DO IT!

Micro Computer Services Inc. began operations on August 1, 2014. At the end of August 2014, management attempted to prepare monthly fi nancial statements. The following information relates to August. (Amounts are in Chinese yuan.)

1. At August 31, the company owed its employees ¥8,000 in salaries and wages that will be paid on September 1.

2. On August 1, the company borrowed ¥300,000 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 ¥11,000.

Prepare the adjusting entries needed at August 31, 2014.

Solution

Action Plan✔ Make adjusting entries

at the end of the period for revenues recog-nized and expenses incurred in the period.

✔ Don’t forget to make adjusting entries for accruals. Adjusting entries for accruals will increase both a statement of fi nancial position and an income statement account.

1. Salaries and Wages Expense 8,000 Salaries and Wages Payable 8,000 (To record accrued salaries)

2. Interest Expense 2,500 Interest Payable 2,500 (To record accrued interest: ¥300,000 3 10% 3 1

12 5 ¥2,500)

3. Accounts Receivable 11,000 Service Revenue 11,000 (To record revenue for services performed)

Related exercise material: BE3-7, E3-5, E3-6, E3-7, E3-8, E3-9, E3-10, E3-11, E3-12, and DO IT! 3-3.

✔ The Navigator

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 statement of fi nancial position account and one income statement account.

What accounting issue might this cause for companies? (See page 153.)

?

PEOPLE, PLANET, AND PROFIT INSIGHTGot Junk?

Do you have an old computer or two that you no longer use? How about an old TV that needs re-placing? 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.



Illustrations 3-23 (below) and 3-24 (on page 116) show the journalizing and posting of adjusting entries for Pioneer Advertising Agency Inc. on October 31. The ledger identifi es 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 fi rst 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.

Helpful Hint1. Adjusting entries should not involve debits or credits to cash.2. Evaluate whether the adjustment makes sense. For example, an adjust-ment to recognize supplies used should increasesupplies expense.3. Double-check allcomputations.4. Each adjusting entry affects one statement of fi nancial position account and one income statement account.

General Journal J2

Date Account Titles and Explanation Ref. Debit Credit

2014 Adjusting Entries

Oct. 31 Supplies Expense 631 1,500 Supplies 126 1,500 (To record supplies used)

31 Insurance Expense 722 50 Prepaid Insurance 130 50 (To record insurance expired)

31 Depreciation Expense 711 40 Accumulated Depreciation—Equipment 158 40 (To record monthly depreciation)

31 Unearned Service Revenue 209 400 Service Revenue 400 400 (To record revenue for services performed)

31 Accounts Receivable 112 200 Service Revenue 400 200 (To record revenue for services performed)

31 Interest Expense 905 50 Interest Payable 230 50 (To record interest on notes payable)

31 Salaries and Wages Expense 726 1,200 Salaries and Wages Payable 212 1,200 (To record accrued salaries and wages)

Illustration 3-23General journal showing adjusting entries

Type of Adjustment Accounts Before Adjustment Adjusting Entry

Prepaid expenses Assets overstated. Dr. Expenses Expenses understated. Cr. Assets or Contra Asset

Unearned revenues Liabilities overstated. Dr. Liabilities Revenues understated. Cr. Revenues

Accrued revenues Assets understated. Dr. Assets Revenues understated. Cr. Revenues

Accrued expenses Expenses understated. Dr. Expenses Liabilities understated. Cr. Liabilities

Illustration 3-22Summary of adjusting entries



Illustration 3-24General ledger after adjustment

General Ledger

Cash No. 101

Date Explanation Ref. Debit Credit Balance

2014

Oct. 1 J1 10,000 10,000

2 J1 1,200 11,200

3 J1 900 10,300

4 J1 600 9,700

20 J1 500 9,200

26 J1 4,000 5,200

31 J1 10,000 15,200

Accounts Receivable No. 112


2014

Oct. 31 Adj. entry J2 200 200

Supplies No. 126


2014

Oct. 5 J1 2,500 2,500

31 Adj. entry J2 1,500 1,000

Prepaid Insurance No. 130


2014

Oct. 4 J1 600 600

31 Adj. entry J2 50 550

Equipment No. 157


2014

Oct. 1 J1 5,000 5,000

Accumulated Depreciation—Equipment No. 158


2014


Notes Payable No. 200


2014

Oct. 1 J1 5,000 5,000

Accounts Payable No. 201


2014

Oct. 5 J1 2,500 2,500

Unearned Service Revenue No. 209


2014

Oct. 2 J1 1,200 1,200

31 Adj. entry J2 400 800

Salaries and Wages Payable No. 212


2014

Oct. 31 Adj. entry J2 1,200 1,200

Interest Payable No. 230


2014


Share Capital—Ordinary No. 311


2014

Oct. 1 J1 10,000 10,000

Retained Earnings No. 320


2014

Dividends No. 332


2014

Oct. 20 J1 500 500

Service Revenue No. 400


2014

Oct. 31 J1 10,000 10,000

31 Adj. entry J2 400 10,400 31 Adj. entry J2 200 10,600

Supplies Expense No. 631


2014

Oct. 31 Adj. entry J2 1,500 1,500

Depreciation Expense No. 711


2014


Insurance Expense No. 722


2014


Salaries and Wages Expense No. 726


2014

Oct. 26 J1 4,000 4,000

31 Adj. entry J2 1,200 5,200

Rent Expense No. 729


2014

Oct. 3 J1 900 900

Interest Expense No. 905


2014



The Adjusted Trial Balance and Financial Statements 117

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 fi nancial statements, the adjusted trial balance is the primary basis for the preparation of fi nancial statements.

Preparing the Adjusted Trial Balance

Illustration 3-25 presents the adjusted trial balance for Pioneer Advertis-ing Agency Inc. 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 101. 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.

Describe the nature and purpose of an adjusted trial balance.


The Adjusted Trial Balance and Financial Statements

Pioneer Advertising Agency Inc.Adjusted Trial Balance

October 31, 2014

Dr. Cr.

Cash 15,200

Accounts Receivable 200Supplies 1,000Prepaid Insurance 550Equipment 5,000

Accumulated Depreciation—Equipment 40Notes Payable 5,000

Accounts Payable 2,500

Interest Payable 50Unearned Service Revenue 800Salaries and Wages Payable 1,200Share Capital—Ordinary 10,000

Retained Earnings –0–

Dividends 500

Service Revenue 10,600

Salaries and Wages Expense 5,200Supplies Expense 1,500Rent Expense 900

Insurance Expense 50Interest Expense 50Depreciation Expense 40

30,190 30,190

Illustration 3-25Adjusted trial balance



Preparing Financial Statements

Companies can prepare fi nancial statements directly from the adjusted trial balance. Illustrations 3-26 and 3-27 present the interrelationships of data in the adjusted trial balance and the fi nancial statements.

As Illustration 3-26 shows, companies prepare the income statement from the revenue and expense accounts. Next, they use the Retained Earnings and Dividends accounts and the net income (or net loss) from the income statement to prepare the retained earnings statement. As Illustration 3-27 shows, compa-nies then prepare the statement of fi nancial position from the asset and liability accounts and the ending retained earnings balance as reported in the retained earnings statement.

Pioneer Advertising Agency Inc.Retained Earnings Statement

For the Month Ended October 31, 2014

Retained earnings, October 1Add: Net income

–0–2,860

2,860

5002,360

Less: DividendsRetained earnings, October 31

To statement of financial position


October 31, 2014

CashAccounts ReceivableSuppliesPrepaid Insurance Office EquipmentAccumulated Depreciation— EquipmentNotes PayableAccounts PayableUnearned Service RevenueSalaries and Wages PayableInterest Payable

15,200200

1,000550

5,000

500

5,2001,500

900505040

405,0002,500

8001,200

5010,000

–0–

10,600

30,190 30,190

Debit Credit

Pioneer Advertising Agency Inc.Income Statement

For the Month Ended October 31, 2014

Revenues Service revenue

Expenses Salaries and wages expense Supplies expense Rent expense Insurance expense Interest expense Depreciation expense

Total expenses

Net income

5,2001,500

900505040

10,600

7,740

2,860

Service RevenueSalaries and Wages ExpenseSupplies ExpenseRent ExpenseInsurance ExpenseInterest ExpenseDepreciation Expense

Share Capital—Ordinary Retained EarningsDividends

Account

Illustration 3-26Preparation of the income statement and retained earnings statement from the adjusted trial balance


The Adjusted Trial Balance and Financial Statements 119

CashAccounts ReceivableSuppliesPrepaid InsuranceEquipmentAccumulated Depreciation— EquipmentNotes PayableAccounts PayableUnearned Service RevenueSalaries and Wages PayableInterest PayableShare Capital —OrdinaryRetained EarningsDividendsService RevenueSalaries and Wages ExpenseSupplies ExpenseRent ExpenseInsurance ExpenseInterest ExpenseDepreciation Expense

15,200200

1,000550

5,000

500

5,2001,500

900505040

405,0002,500

8001,200

5010,000

–0–

10,600

30,190 30,190

Account Debit Credit

Pioneer Advertising Agency Inc.Statement of Financial Position

October 31, 2014

EquipmentLess: Accumulated depreciation —equip.Prepaid insuranceSuppliesAccounts receivableCashTotal assets

5,000

40

Assets

4,960550

1,000 200

15,20021,910

Equity and Liabilities


October 31, 2014

21,910Total equity and liabilities

Equity Share capital—ordinary Retained earnings

10,0002,360

5,000 2,500 800 1,200

50 9,550

12,360

Balance at Oct. 31 from Retained EarningsStatement in Illustration 3-26

Liabilities Notes payable Accounts payable Unearned service revenue Salaries and wages payable Interest payable

Illustration 3-27Preparation of the statement of fi nancial position from the adjusted trial balance

Trial balance

> DO IT!

Kang Company was organized on April 1, 2014. The company prepares quarterly fi nancial statements. The adjusted trial balance amounts at June 30 are shown below. (Amounts are in millions.)

Debit Credit

Cash W 6,700 Accumulated Depreciation—Equipment W 850Accounts Receivable 600 Notes Payable 5,000Prepaid Rent 900 Accounts Payable 1,510Supplies 1,000 Salaries and Wages Payable 400Equipment 15,000 Interest Payable 50Dividends 600 Unearned Rent Revenue 500Salaries and Wages Expense 9,400 Share Capital—Ordinary 14,000Rent Expense 1,500 Service Revenue 14,200Depreciation Expense 850 Rent Revenue 800Supplies Expense 200Utilities Expense 510Interest Expense 50

Total debits W37,310 Total credits W37,310



Related exercise material: BE3-9, BE3-10, E3-11, E3-13, and DO IT! 3-4.

✔ The Navigator

Action Plan✔ In an adjusted trial

balance, all assets, liability, revenue, and expense accounts are properly stated.

✔ To determine the ending balance in retained earnings, add net income and subtract dividends.

(a) The net income is determined by adding revenues and subtracting expenses. The net income is computed as follows (in millions).

Revenues Service revenue W14,200 Rent revenue 800 Total revenues W15,000

Expenses Salaries and wages expense W 9,400 Rent expense 1,500 Depreciation expense 850 Utilities expense 510 Supplies expense 200 Interest expense 50 Total expenses 12,510

Net income W 2,490

(b) Total assets and liabilities are computed as follows (in millions).

Assets Liabilities

Equipment W15,000 Notes payable W5,000 Less: Accumulated Accounts payable 1,510 depreciation— Unearned rent equipment 850 W14,150 revenue 500 Prepaid rent 900 Salaries and wages Supplies 1,000 payable 400 Accounts receivable 600 Interest payable 50 Cash 6,700

Total assets W23,350 Total liabilities W7,460

(c) Retained earnings, April 1 W 0 Add: Net income 2,490 Less: Dividends 600

Retained earnings, June 30 W 1,890

(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 Kang Co.

(c) Determine the amount that appears for retained earnings at June 30, 2014.

Solution

> DO IT!

The Green Thumb Lawn Care Inc. began on April 1. At April 30, the trial balance shows the following balances for selected accounts. (Amounts are in Chinese yuan.)

Prepaid Insurance ¥ 36,000Equipment 280,000Notes Payable 200,000Unearned Service Revenue 42,000Service Revenue 18,000

Comprehensive


Summary of Learning Objectives 121

Action Plan✔ Note that adjustments

are being made for one month.

✔ Make computations carefully.

✔ Select account titles carefully.

✔ Make sure debits are made fi rst and credits are indented.

✔ Check that debits equal credits for each entry.

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 ¥5,000 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 months’ lawn service package of ¥6,000 beginning in April. The company performed services for these customers in April.

5. Lawn services provided to other customers but not recorded at April 30 totaled ¥15,000.

InstructionsPrepare the adjusting entries for the month of April. Show computations.

Solution to Comprehensive

GENERAL JOURNAL J1 Date Account Titles and Explanation Ref. Debit Credit

Adjusting Entries

Apr. 30 Insurance Expense 1,500 Prepaid Insurance 1,500 (To record insurance expired: ¥36,000 4 24 5 ¥1,500 per month)

30 Depreciation Expense 5,000 Accumulated Depreciation—Equipment 5,000 (To record monthly depreciation)

30 Interest Expense 2,000 Interest Payable 2,000 (To record interest on notes payable: ¥200,000 3 12% 3 1/12 5 ¥2,000)

30 Unearned Service Revenue 7,000 Service Revenue 7,000 (To record revenue for services performed: ¥6,000 4 6 5 ¥1,000; ¥1,000 per month 3 7 5 ¥7,000)

30 Accounts Receivable 15,000 Service Revenue 15,000 (To record revenue for services performed)

DO IT!

✔ The Navigator

1 Explain the time period assumption. The time period assumption assumes that the economic life of a busi-ness is divided into artifi cial time periods.

2 Explain the accrual basis of accounting. Accrual-basis accounting means that companies record events that change a company’s fi nancial 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. 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 satisfi ed and recognize expenses in the period in which they are incurred.

4 Identify the major types of adjusting entries. The major types of adjusting entries are deferrals (prepaid expenses and unearned revenues) and accruals (accrued revenues and accrued expenses).

5 Prepare adjusting entries for deferrals. Deferrals are either prepaid expenses or unearned revenues.

SUMMARY OF LEARNING OBJECTIVES ✔ The Navigator



current accounting period that have not been recog-nized through daily entries.

7 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.

Companies make adjusting entries for deferrals to re-cord the portion of the prepayment that represents the expense incurred or the revenue for services performed in the current accounting period.

6 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

Accrual-basis accounting Accounting basis in which companies record transactions that change a company’s fi nancial statements in the periods in which the events occur. (p. 98).

Accruals Adjusting entries for either accrued revenues or accrued expenses. (p. 101).

Accrued expenses Expenses incurred but not yet paid in cash or recorded. (p. 110).

Accrued revenues Revenues for services performed but not yet received in cash or recorded. (p. 109).

Adjusted trial balance A list of accounts and their bal-ances after the company has made all adjustments. (p. 117).

Adjusting entries Entries made at the end of an ac-counting period to ensure that companies follow the revenue and expense recognition principles. (p. 100).

Book value The difference between the cost of a depre-ciable asset and its related accumulated depreciation. (p. 105).

Calendar year An accounting period that extends from January 1 to December 31. (p. 98).

Cash-basis accounting Accounting basis in which com-panies record revenue when they receive cash and an expense when they pay cash. (p. 98).

Contra asset account An account offset against an asset account on the statement of fi nancial position. (p. 104).

Deferrals Adjusting entries for either prepaid expenses or unearned revenues. (p. 101).

Depreciation The allocation of the cost of an asset to expense over its useful life in a rational and systematic manner. (p. 104).

Expense recognition (matching) principle The prin-ciple that companies match efforts (expenses) with accomplishments (revenues). (p. 99).

Fiscal year An accounting period that is one year in length. (p. 98).

Interim periods Monthly or quarterly accounting time periods. (p. 98).

Prepaid expenses (prepayments) Expenses paid in cash before they are used or consumed. (p. 102).

Revenue recognition principle The principle that companies recognize revenue in the accounting period in which the performance obligation is satis-fi ed. (p. 99).

Time period assumption An assumption that accoun-tants can divide the economic life of a business into artifi cial time periods. (p. 98).

Unearned revenue Cash received and recorded as a liability before services are performed. (p. 106).

Useful life The length of service of a long-lived asset. (p. 104).

GLOSSARY

In discussing adjusting entries for prepaid expenses and unearned revenues, we illustrated transactions for which companies made the initial entries to statement of fi nancial position 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.

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

Prepare adjusting entries for the alternativetreatment of deferrals.

8LEARNING OBJECTIVE

APPENDIX 3A ALTERNATIVE TREATMENT OF PREPAID EXPENSES AND UNEARNED REVENUES


Appendix 3A: Alternative Treatment of Prepaid Expenses and Unearned Revenues 123

expenses and unearned revenues has the same effect on the fi nancial 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 fi nancial 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 Inc. 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 Sup-plies 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.

Oct. 31 Supplies 1,000 Supplies Expense 1,000 (To record supplies inventory)

After the company posts the adjusting entry, the accounts show:

11,000 11,000 Exp

Cash Flowsno effect

A EL5 1

Supplies Supplies Expense

10/31 Adj. 1,000 10/5 2,500 10/31 Adj. 1,000

10/31 Bal. 1,500

Illustration 3A-1Prepaid 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 Ex-pense 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 equity are understated by 1,000 on the October 31 statement of fi nancial position.

Illustration 3A-2 compares the entries and accounts for advertising supplies in the two adjustment approaches.

Prepayment Initially Prepayment Initially Debited to Asset Account Debited to Expense Account (per chapter) (per appendix)

Oct. 5 Supplies 2,500 Oct. 5 Supplies Expense 2,500 Accounts Payable 2,500 Accounts Payable 2,500

Oct. 31 Supplies Expense 1,500 Oct. 31 Supplies 1,000 Supplies 1,500 Supplies Expense 1,000

Illustration 3A-2Adjustment approaches—a comparison



After Pioneer posts the entries, the accounts appear as follows.

(per chapter) (per appendix) Supplies Supplies

10/5 2,500 10/31 Adj. 1,500 10/31 Adj. 1,000

10/31 Bal. 1,000

Supplies Expense Supplies Expense

10/31 Adj. 1,500 10/5 2,500 10/31 Adj. 1,000

10/31 Bal. 1,500

Illustration 3A-3Comparison of accounts

Unearned Service Revenue Service Revenue

10/31 Adj. 800 10/31 Adj. 800 10/2 1,200

10/31 Bal. 400

Illustration 3A-4Unearned service revenueaccounts 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 equity is overstated by 800 on the October 31 statement of fi nancial position.

Illustration 3A-5 compares the entries and accounts for initially recording unearned service revenue in (1) a liability account or (2) a revenue account.

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).

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 Agency Inc. 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.

Oct. 31 Service Revenue 800 Unearned Service Revenue 800 (To record unearned service revenue)

After Pioneer posts the adjusting entry, the accounts show:

Helpful HintThe required adjustedbalances here are Service Revenue 400 andUnearned ServiceRevenue 800.

2800 Rev 1800

Cash Flowsno effect

A EL5 1


Summary of Learning Objective for Appendix 3A 125

After Pioneer posts the entries, the accounts appear as follows.

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.

Unearned Service Revenue Unearned Service Revenue Initially Credited Initially Credited to Liability Account to Revenue Account (per chapter) (per appendix)

Oct. 2 Cash 1,200 Oct. 2 Cash 1,200 Unearned Service Service Revenue 1,200 Revenue 1,200

Oct. 31 Unearned Service Oct. 31 Service Revenue 800 Revenue 400 Unearned Service Service Revenue 400 Revenue 800

Illustration 3A-5Adjustment approaches—a comparison

(per chapter) (per appendix) Unearned Service Revenue Unearned Service Revenue

10/31 Adj. 400 10/2 1,200 10/31 Adj. 800

10/31 Bal. 800

Service Revenue Service Revenue

10/31 Adj. 400 10/31 Adj. 800 10/2 1,200

10/31 Bal. 400

Illustration 3A-6Comparison of accounts

Illustration 3A-7Summary of basic relationships for deferrals.

Type of Reason for Account Balances Adjusting Adjustment Adjustment Before Adjustment Entry

Prepaid expenses (a) Prepaid expenses initially recorded Assets overstated. Dr. Expenses in asset accounts have been used. Expenses understated. Cr. Assets

(b) Prepaid expenses initially recorded in Assets understated. Dr. Assets expense accounts have not been used. Expenses overstated. Cr. Expenses

Unearned revenues (a) Unearned revenues initially recorded Liabilities overstated. Dr. Liabilities in liability accounts are now recognized Revenues understated. Cr. Revenues as revenue.

(b) Unearned revenues initially recorded Liabilities understated. Dr. Revenues in revenue accounts are still unearned. Revenues overstated. Cr. Liabilities

Alternative adjusting entries do not apply to accrued revenues and accrued expenses because no entries occur before companies make these types of adjusting entries.

8 Prepare adjusting entries for the alternative treatment of deferrals. Companies may initially debit prepay-ments 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 include a debit to an asset account and a credit to an expense account. Adjusting entries for unearned revenues include a debit to a revenue account and a credit to a liability account.

SUMMARY OF LEARNING OBJECTIVE FOR APPENDIX 3A ✔ The Navigator



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 fi nancial information.

Qualities of Useful Information

Recently, the IASB and FASB completed the fi rst phase of a joint project in which they developed a conceptual framework to serve as the basis for future account-ing standards. The framework begins by stating that the primary objective of fi nancial reporting is to provide fi nancial information that is useful to inves-tors and creditors for making decisions about providing capital. According to the IASB, useful information should possess two fundamental qualities, relevance and faithful representation, as shown in Illustration 3B-1.

Discuss fi nancialreporting concepts.

9LEARNING OBJECTIVE

APPENDIX 3B CONCEPTS IN ACTION

ENHANCING QUALITIESIn addition to the two fundamental qualities, the IASB and FASB also describe a number of enhancing qualities of useful information. These include comparability, consistency, verifi ability, timeliness, and understandability. In accounting, com-parability 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 verifi able if independent measures, 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 infl uence decisions. For example, public companies like Google (USA) or Best Buy (USA) must 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

Relevance Accounting information has relevance if it would make a difference in a business decision. Informationis considered relevant if it provides information that has predictive value, that is, helps provide accurate expectations about the future, and has confi rmatory value, that is, confi rms or corrects prior expectations. In addition, materiality is a company-specifi c aspect of relevance. An item is material when its size makes it likely to infl uence the decision of an investor or creditor.

BIGSHOT

Tell me whatI need to know.

Faithful Representation Faithful representation means that information accurately depicts what really happened. To provide a faithful representation, information must be complete (nothing important has been omitted), neutral (is not biased toward one position or another), and free from error. So sentence should read: To provide faithful representation, information must be complete (nothing important has been omitted), neutral (is not biased toward one position or another), and free from error.

Illustration 3B-1Fundamental qualities ofuseful information


Appendix 3B: Concepts in Action 127

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 IASB 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.

Going Concern Assumption The going concern assump-tion (discussed in Chapter 9) states that the business will remain in operation for the foreseeable future. Of course, many businesses do fail, but in general, it is reasonable to assume that the business will continue operating.Now Future

Principles in Financial Reporting

MEASUREMENT PRINCIPLESIFRS generally uses one of two measurement principles, the historical cost principle or the fair value principle. Selection of which principle to follow gen-erally 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.

Monetary Unit Assumption The monetary unit assumption (discussed in Chapter 1) requires that only those things that can be expressed in money are included in the accounting records. This means that certain important information needed by investors, creditors, and managers, such as customer satisfaction, is not reported in the fi nancial statements.

Economic Entity Assumption The economic entity assump-tion (discussed in Chapter 1) states that the activities of the entity must be kept separate and distinct from the activities of the owner. In order to assess a company’s performance and fi nancial position accurately, it is important that we not blur company transactions with personal transactions (especially those of its managers) or transactions of other companies.

Time Period (Periodicity) Assumption Notice that the income statement, retained earnings statement, and statement of cash fl ows all cover periods of one year, and the statement of fi nancial position is prepared at the end of each year. The time period assumption (discussed in Chapter 3) states that the life of a business can be divided into artifi cial time periods and that useful reports covering those periods can be prepared for the business.

Acct.Records-Salaries paidMeasure ofemployeesatisfaction

Salaries paid

Total numberof employees

Percent ofinternationalemployees

Tata

Kia

Volkswagen

FORD

CHRYSLER

G eneral Motors

Start ofbusiness

End ofbusiness

2004

2006 2008 2010 2012

2014

J F

QTR1

QTR2

QTR3

QTR4

M A M J J A S O N D

Illustration 3B-2Key assumptions in fi nancial reporting

The importance of the economic entity as-sumption is illustrated by scandals involving Adelphia (USA). In this case, senior company employees entered into transactions that blurred the line be-tween the employees’ fi nancial interests and those of the company. For example, Adelphia guaranteed over $2 billion of loans to the founding family.

Ethics Note



FAIR VALUE PRINCIPLE The fair value principle (discussed in Chapter 1) in-dicates 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 be-tween cost and fair value, two qualities that make accounting information useful for decision-making are used—relevance and faithful representation. In deter-mining which measurement principle to use, the factual nature of cost fi gures are weighed versus the relevance of fair value. In general, most assets follow the historical cost principle because market values are representationally faithful. Only in situations where assets are actively traded, such as investment securi-ties, is the fair value principle applied.

REVENUE RECOGNITION PRINCIPLEThe revenue recognition principle requires that companies recognize revenue in the accounting period in which the performance obligation is satisfi ed. As dis-cussed in Chapter 3, in a service company, revenue is recognized at the time the service is performed. In a merchandising company, the performance obligation is generally satisfi ed when the goods transfer from the seller to the buyer (discussed in Chapter 4). At this point, the sales transaction is complete and the sales price established.

EXPENSE RECOGNITION PRINCIPLEThe expense recognition principle (often referred to as the matching principle, discussed in Chapter 3) dictates that efforts (expenses) be matched with results (revenues). Thus, expenses follow revenues.

FULL DISCLOSURE PRINCIPLEThe full disclosure principle (discussed in Chapter 11) requires that companies disclose all circumstances and events that would make a difference to fi nancial statement users. If an important item cannot reasonably be reported directly in one of the four types of fi nancial statements, then it should be discussed in notes that accompany the statements.

Cost Constraint

The cost constraint relates to the fact that providing information is costly. In deciding whether companies should be required to provide a certain type of in-formation, accounting standard-setters weigh the cost that companies will incur to provide the information against the benefi t that fi nancial statement users will gain from having the information available.

9 Discuss fi nancial reporting concepts. To be judged useful, information should have the primary characteristics of relevance and faithful representation. In addition, it should be comparable, consistent, verifi able, timely, and understandable.

The monetary unit assumption requires that com-panies include in the accounting records only trans-action data that can be expressed in terms of money. The economic entity assumption states that economic

events can be identifi ed with a particular unit of ac-countability. The time period assumption states that the economic life of a business can be divided into artifi cial 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.

SUMMARY OF LEARNING OBJECTIVE FOR APPENDIX 3B ✔ The Navigator


Glossary for Appendix 3B 129

GLOSSARY FOR APPENDIX 3B

Comparability Ability to compare the accounting in-formation of different companies because they use the same accounting principles. (p. 126).

Consistency Use of the same accounting principles and methods from year to year within a company. (p. 126).

Cost constraint Constraint of determining whether the cost that companies will incur to provide the informa-tion will outweigh the benefi t that fi nancial statement users will gain from having the information available. (p. 128).

Economic entity assumption An assumption that every economic entity can be separately identifi ed and accounted for. (p. 127).

Expense recognition principle Efforts (expenses) should be matched with results (revenues). (p. 128)

Fair value principle Assets and liabilities should be reported at fair value (the price received to sell an asset or settle a liability). (p. 128).

Faithful representation Information that accurately depicts what really happened. (p. 126).

Full disclosure principle Accounting principle that dictates that companies disclose circumstances and events that make a difference to fi nancial statement users. (p. 128).

Going concern assumption The assumption that the company will continue in operation for the foreseeable future. (p. 127).

Historical cost principle An accounting principle that states that companies should record assets at their cost. (p. 127).

Materiality A company-specifi c aspect of relevance. An item is material when its size makes it likely to infl u-ence the decision of an investor or creditor. (p. 127).

Monetary unit assumption An assumption that requires that only those things that can be expressed in money are included in the accounting records. (p. 127).

Relevance The quality of information that indicates the information makes a difference in a decision. (p. 126).

Revenue recognition principle Companies recognize revenue in the accounting period in which the perfor-mance obligation is satisfi ed. (p. 128).

Timely Information that is available to decision-makers before it loses its capacity to infl uence decisions. (p. 126).

Time period assumption An assumption that the life of a business can be divided into artifi cial time periods and that useful reports covering those periods can be prepared for the business. (p. 127).

Understandability Information presented in a clear and concise fashion so that users can interpret it and com-prehend its meaning. (p. 126).

Verifi able The quality of information that occurs when independent measures, using the same methods, obtain similar results. (p. 126).

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 pe-riod in which the performance obligation is satisfi ed. 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 fi nancial state-ment users.

The cost constraint weighs the cost that companies incur to provide a type of information against its benefi ts to fi nancial statement users.

Self-Test, Brief Exercises, Exercises, Problem Set A, and many more components are availablefor practice in WileyPLUS.

Note: All Questions, Exercises, and Problems marked with an asterisk relate to material in the appendices to the chapter.

Answers are on page 153. 1. The revenue recognition principle states that:

(a) revenue should be recognized in the account-ing period in which a performance obligation is satisfi ed.

(LO 1)(b) expenses should be matched with revenues.(c) the economic life of a business can be divided

into artifi cial time periods.(d) the fi scal year should correspond with the calendar

year.

SELF-TEST QUESTIONS



2. The time period assumption states that:(a) companies must wait until the calendar year is

completed to prepare fi nancial statements.(b) companies use the fi scal year to report fi nancial

information.(c) the economic life of a business can be divided

into artifi cial time periods.(d) companies record information in the time period

in which the events occur.

3. Which of the following statements about the accrual basis of accounting is false?(a) Events that change a company’s fi nancial state-

ments are recorded in the periods in which the events occur.

(b) Revenue is recognized in the period in which ser-vices are performed.

(c) The accrual basis is in accord with IFRS.(d) Revenue is recorded only when cash is re-

ceived, and expense is recorded only when cash is paid.

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 principle.(d) revenue recognition principle.

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 provided.(c) statement of fi nancial position and income state-

ment accounts have correct balances at the end of an accounting period.

(d) All the responses above are correct.

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.

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 600 Supplies Expense 600(b) Supplies 750 Supplies Expense 750(c) Supplies Expense 750 Supplies 750(d) Supplies Expense 600 Supplies 600

8. Adjustments for prepaid expenses:(a) decrease assets and increase revenues.(b) decrease expenses and increase assets.

(LO 1)

(LO 2)

(LO 2)

(LO 3)

(LO 4)

(LO 5)

(LO 5)

(c) decrease assets and increase expenses.(d) decrease revenues and increase assets.

9. Accumulated Depreciation is:(a) a contra asset account.(b) an expense account.(c) an equity account.(d) a liability account.

10. Queenan Company computes depreciation on de-livery equipment at $1,000 for the month of June. The adjusting entry to record this depreciation is as follows.(a) Accumulated Depreciation—

Queenan Company 1,000 Depreciation Expense 1,000(b) Depreciation Expense 1,000 Equipment 1,000(c) Depreciation Expense 1,000 Accumulated Depreciation—

Equipment 1,000(d) Equipment Expense 1,000 Accumulated Depreciation—

Equipment 1,000

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.

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.

13. Kathy Siska earned a salary of R$400 for the last week of September. She will be paid on October 1. The adjusting entry for Kathy’s employer at Septem-ber 30 is:(a) No entry is required.(b) Salaries and Wages Expense 400 Salaries and Wages Payable 400(c) Salaries and Wages Expense 400 Cash 400(d) Salaries and Wages Payable 400 Cash 400

14. Which of the following statements is incorrect con-cerning 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 fi nancial statements.

(c) The adjusted trial balance lists the account bal-ances segregated by assets and liabilities.

(d) The adjusted trial balance is prepared after the adjusting entries have been journalized and posted.

(LO 5)

(LO 5)

(LO 5)

(LO 6)

(LO 6)

(LO 7)


Questions 131

*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:

Faithful Representation Relevance

(a) Yes Yes (b) No No (c) Yes No (d) No Yes

*17. Which item is a constraint in fi nancial accounting?(a) Comparability. (c) Cost.(b) Materiality. (d) Consistency.

(LO 9)

(LO 9)

Go to the book’s companion website, www.wiley.com/college/weygandt, for additional Self-Test Questions.

✔ The Navigator

1. (a) How does the time period assumption affect an accountant’s analysis of business transactions?

(b) Explain the terms fi scal year, calendar year, and interim periods.

2. Defi ne two IFRS principles that relate to adjusting the accounts.

3. Gabe Corts, a lawyer, accepts a legal engagement in March, performs the work in April, and is paid in May. If Corts’ law fi rm prepares monthly fi nancial statements, when should it recognize revenue from this engagement? Why?

4. Why do accrual-basis fi nancial statements provide more useful information than cash-basis statements?

5. In completing the engagement in Question 3, Corts pays no costs in March, $2,200 in April, and $2,500 in May (incurred in April). How much expense should the fi rm 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 fi nancial information?

8. Distinguish between the two categories of adjusting entries, and identify the types of adjustments appli-cable 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. Jain Company purchased equipment for Rs18,000,000. By the current statement of fi nancial position date, Rs7,000,000 had been depreciated. Indicate the state-ment of fi nancial position 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 $6,000 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 ex-pense) that is needed to correct the misstatement. If an item could result in more than one type of adjust-ing 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. Indi-cate the account title for the other half of the entry.(a) Salaries and Wages Expense is debited.(b) Depreciation Expense is debited.

QUESTIONS



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 diffi cult 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.

(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 statement of fi nancial position or income statement account.” Do you agree? Why or why not?

21. Why is it possible to prepare fi nancial statements directly from an adjusted trial balance?

*22. L. Thomas 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 fi nancial 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

BRIEF EXERCISES

BE3-1 The ledger of Basler 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

BE3-2 Lucci 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 $870.3. Interest of $200 has accumulated on a note payable.4. Rent collected in advance totaling $560 has been recognized.

BE3-3 Wow Advertising Company’s trial balance at December 31 shows Supplies £6,700 and Supplies Expense £0. On December 31, there are £1,900 of supplies on hand. Prepare the adjusting entry at December 31, and using T-accounts, enter the balances in the ac-counts, post the adjusting entry, and indicate the adjusted balance in each account.

BE3-4 At the end of its fi rst year, the trial balance of Wooster Company shows Equipment $32,000 and zero balances in Accumulated Depreciation—Equipment and Depreciation Expense. Depreciation for the year is estimated to be $6,000. Prepare the adjusting entry for depreciation at December 31, post the adjustments to T-accounts, and indicate the statement of fi nancial position presentation of the equipment at December 31.

BE3-5 On July 1, 2014, Pizner Co. pays $13,200 to Orlow Insurance Co. for a 3-year in-surance contract. Both companies have fi scal years ending December 31. For Pizner Co., journalize and post the entry on July 1 and the adjusting entry on December 31.

BE3-6 Using the data in BE3-5, journalize and post the entry on July 1 and the adjusting entry on December 31 for Orlow Insurance Co. Orlow uses the accounts Unearned Service Revenue and Service Revenue.

BE3-7 The bookkeeper for Easton Company asks you to prepare the following accrued adjusting entries at December 31.

1. Interest on notes payable of €360 is accrued.2. Services provided but not recorded total €1,750.3. Salaries earned by employees of €900 have not been recorded.

Indicate why adjusting entries are needed.

(LO 3)

Identify the major types of adjusting entries.

(LO 4, 5, 6)

Prepare adjusting entry for supplies.

(LO 5)

Prepare adjusting entryfor depreciation.

(LO 5)

Prepare adjusting entryfor prepaid expense.

(LO 5)Prepare adjusting entryfor unearned revenue.

(LO 5)Prepare adjusting entriesfor accruals.

(LO 6)


Brief Exercises 133

Use the following account titles: Service Revenue, Accounts Receivable, Interest Expense, Interest Payable, Salaries and Wages Expense, and Salaries and Wages Payable.

BE3-8 The trial balance of Gleason Company includes the following statement of fi nancial position accounts, which may require adjustment. For each account that requires adjust-ment, 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 PayablePrepaid Insurance Unearned Service RevenueAccumulated Depreciation—Equipment

BE3-9 The adjusted trial balance of Kwun Company at December 31, 2014, includes the fol-lowing accounts (in thousands): Share Capital—Ordinary W15,600; Dividends W6,000; Service Revenue W38,400; Salaries and Wages Expense W16,000; Insurance Expense W2,000; Rent Expense W4,400; Supplies Expense W1,500; and Depreciation Expense W1,300. Prepare an income statement for the year.

BE3-10 Partial adjusted trial balance data for Kwun Company is presented in BE3-9. Pre-pare a retained earnings statement for the year assuming net income is W13,200 for the year and Retained Earnings is W7,240 on January 1. (Amounts are in thousands.)

*BE3-11 Lim 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 statement of fi nancial position accounts. Prepare the adjusting entries at April 30 assuming (a) $1,000 of supplies on hand and (b) $2,000 of service revenue should be reported as unearned.

*BE3-12 The accompanying chart shows the qualitative characteristics of useful accounting information. Fill in the blanks.

Analyze accounts in anunadjusted trial balance.

(LO 4, 5, 6)

Prepare an income statement from an adjusted trial balance.

(LO 7)

Prepare a retained earnings statement from an adjusted trial balance.

(LO 7)Prepare adjusting entriesunder alternative treatmentof deferrals.

(LO 8)

Identify characteristics of useful information.

(LO 9)

UsefulnessEnhancingQualities

Relevance

(a)

(b)

(c)

Consistency

(f)

(g)

(h)

Understandability

FundamentalQualities

FaithfulRepresentation

(d)

Neutral

(e)

*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, confi rmatory 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.

*BE3-14 Here are some qualitative characteristics of useful accounting information:1. Predictive value 3. Verifi able2. Neutral 4. Timely


(LO 9)


(LO 9)



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 measures, using the same methods, obtain similar results.

———— (d) Accounting information must be available to decision-makers before it loses its capacity to infl uence their decisions.

*BE3-15 The full disclosure principle dictates that:

(a) fi nancial statements should disclose all assets at their cost.(b) fi nancial statements should disclose only those events that can be measured in currency.(c) fi nancial statements should disclose all events and circumstances that would matter to

users of fi nancial statements.(d) fi nancial statements should not be relied on unless an auditor has expressed an

unqualifi ed opinion on them.

Defi ne full disclosureprinciple.

(LO 9)

> DO IT! REVIEW

Several timing concepts are discussed on pages 98–99. 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.2. ______ Fiscal year.3. ______ Revenue recognition principle.4. ______ Expense recognition principle.

Identify timing concepts.

(LO 1, 2)

DO IT! 3-1

(a) Monthly and quarterly time periods.(b) Accountants divide the economic life of

a business into artifi cial time periods.(c) Efforts (expenses) should be matched

with accomplishments (revenues).(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 obliga-tion is satisfi ed.

DO IT! 3-2

DO IT! 3-3

The ledger of Lafayette, Inc. on March 31, 2014, includes the following selected accounts before adjusting entries.

Debit Credit

Prepaid Insurance 2,400Supplies 2,500Equipment 30,000Unearned Service Revenue 9,000


1. Insurance expires at the rate of CHF300 per month.2. Supplies on hand total CHF1,400.3. The equipment depreciates CHF200 per month.4. 2/5 of the unearned service revenue was recognized in March.

Prepare the adjusting entries for the month of March.

Pegasus Computer Services began operations in July 2014. At the end of the month, the company is trying to prepare monthly fi nancial statements. Pegasus has the following information for the month.

Prepare adjusting entriesfor deferrals.

(LO 5)

Prepare adjusting entriesfor accruals.

(LO 6)


Exercises 135

1. At July 31, Pegasus owed employees $1,300 in salaries that the company will pay in August.

2. On July 1, Pegasus borrowed $20,000 from a local bank on a 10-year note. The annual interest rate is 9%.

3. Service revenue unrecorded in July totaled $2,400.

Prepare the adjusting entries needed at July 31, 2014.

Natal Co. was organized on April 1, 2014. The company prepares quarterly fi nancial statements. The adjusted trial balance amounts at June 30 are shown below.

Debit Credit

Cash R$ 5,190 Accumulated Depreciation— R$ 700Accounts Receivable 480 EquipmentPrepaid Rent 720 Notes Payable 4,000Supplies 920 Accounts Payable 790Equipment 12,000 Salaries and Wages Payable 300Dividends 500 Interest Payable 40Salaries and Wages Expense 7,400 Unearned Rent Revenue 400Rent Expense 1,200 Share Capital—Ordinary 11,200Depreciation Expense 700 Service Revenue 11,360Supplies Expense 160 Rent Revenue 900Utilities Expense 380 Total credits R$29,690Interest Expense 40

Total debits R$29,690

(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 Natal Company.(c) Determine the amount that appears for Retained Earnings at June 30, 2014.

Calculate amounts fromtrial balance.

(LO 7)

DO IT! 3-4

✔ The Navigator

EXERCISES

E3-1 Fred Mosure 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 artifi cial time periods.

2. The tax authorities require companies to fi le annual tax returns.3. Accountants divide the economic life of a business into artifi cial 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 fi scal years are calendar years, but not all calendar years are fi scal years.

InstructionsIdentify each statement as true or false. If false, indicate how to correct the statement.

E3-2 On numerous occasions, proposals have surfaced to put the national governments 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 defi cit would increase substantially.

Instructions (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 government offi cial explaining why the government should adopt

the accrual basis of accounting.

Explain the time periodassumption.

(LO 1)

Distinguish between cash and accrual basis of accounting.

(LO 2)



E3-3 Concordia Industries collected $105,000 from customers in 2014. Of the amount collected, $28,000 was from revenue accrued from services performed in 2013. In addition, Concordia recognized $44,000 of revenue in 2014, which will not be collected until 2015.

Concordia 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, Concordia incurred $37,000 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.

E3-4 Yilmaz Corporation encounters the following situations:

1. Yilmaz collects 1,750 from a customer in 2014 for services to be performed in 2015. 2. Yilmaz incurs utility expense which is not yet paid in cash or recorded. 3. Yilmaz employees worked 3 days in 2014 but will not be paid until 2015. 4. Yilmaz performs services for a customer but has not yet received cash or recorded the

transaction. 5. Yilmaz paid 2,400 rent on December 1 for the 4 months starting December 1. 6. Yilmaz received cash for future services and recorded a liability until the service was

performed. 7. Yilmaz 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. Yilmaz paid cash for an expense and recorded an asset until the item was used up. 9. Yilmaz purchased 750 of supplies in 2014; at year-end, 400 of supplies remain

unused.10. Yilmaz purchased equipment on January 1, 2014; the equipment will be used for 5 years.11. Yilmaz borrowed 10,000 on October 1, 2014, signing an 8% one-year note payable.

InstructionsIdentify what type of adjusting entry (prepaid expense, unearned revenue, accrued expense, or accrued revenue) is needed in each situation, at December 31, 2014.

E3-5 Dan Luther Company has the following balances in selected accounts on December 31, 2014.

Accounts Receivable $ –0–Accumulated Depreciation—Equipment –0–Equipment 7,000Interest Payable –0–Notes Payable 8,000Prepaid Insurance 2,100Salaries and Wages Payable –0–Supplies 2,450Unearned Service Revenue 30,000

All the accounts have normal balances. The information below has been gathered at December 31, 2014.

1. Dan Luther Company borrowed $8,000 by signing a 10%, one-year note on October 1, 2014.2. A count of supplies on December 31, 2014, indicates that supplies of $780 are on hand.3. Depreciation on the equipment for 2014 is $1,000.4. Dan Luther Company paid $2,100 for 12 months of insurance coverage on June 1, 2014.5. On December 1, 2014, Dan Luther collected $30,000 for consulting services to be

performed from December 1, 2014, through March 31, 2015.6. Dan Luther performed consulting services for a client in December 2014. The client will

be billed $3,900.7. Dan Luther Company pays its employees total salaries of $9,000 every Monday for the pre-

ceding 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.

InstructionsPrepare annual adjusting entries for the seven items described above.

E3-6 Orwell Company accumulates the following adjustment data at December 31.

1. Services provided but not recorded total €1,420.2. Supplies of €300 have been used.

Compute cash and accrual accounting income.

(LO 2)

Identify the type of adjusting entry needed.

(LO 4)

Prepare adjusting entries from selected data.

(LO 5, 6)

Identify types of adjustments and account relationships.

(LO 4, 5, 6)


Exercises 137

3. Utility expenses of €225 are unpaid.4. Unearned service revenue of €260 is recognized for services performed.5. Salaries of €800 are unpaid.6. Prepaid insurance totaling €380 has expired.

InstructionsFor 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).

E3-7 The ledger of Villa Rental Agency on March 31 of the current year includes the selected accounts, shown below, before adjusting entries have been prepared.

Debit Credit

Prepaid Insurance $ 3,600Supplies 2,800Equipment 25,000Accumulated Depreciation—Equipment $ 8,400Notes Payable 20,000Unearned Rent Revenue 9,900Rent Revenue 60,000Interest Expense –0–Salaries and Wages Expense 14,000


1. The equipment depreciates $300 per month.2. One-third of the unearned rent revenue was recognized during the quarter.3. Interest of $500 is accrued on the notes payable.4. Supplies on hand total $650.5. Insurance expires at the rate of $200 per month.

InstructionsPrepare the adjusting entries at March 31, assuming that adjusting entries are made quar-terly. Additional accounts are Depreciation Expense, Insurance Expense, Interest Pay-able, and Supplies Expense.

E3-8 Kaya Abbas, D.D.S., opened a dental practice on January 1, 2014. During the fi rst 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 520.3. 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 six-month malpractice insurance policy on January 1 for 18,000.5. Purchased 1,600 of dental supplies. On January 31, determined that 700 of supplies

were on hand.

InstructionsPrepare 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.

E3-9 The trial balance for Pioneer Advertising Agency Inc. is shown in Illustration 3-3, page 101. In lieu of the adjusting entries shown in the text at October 31, assume the following adjustment data.

1. Supplies on hand at October 31 total 800.2. Expired insurance for the month is 100.3. Depreciation for the month is 50.4. Unearned service revenue recognized in October totals 600.

Prepare adjusting entries from selected account data.

(LO 5, 6)

Prepare adjusting entries.

(LO 5, 6)

Prepare adjusting entries.

(LO 5, 6)



5. Services provided but not recorded at October 31 are 300.6. Interest accrued at October 31 is 70.7. Accrued salaries at October 31 are 1,200.

InstructionsPrepare the adjusting entries for the items above.

E3-10 The income statement of Midland Co. for the month of July shows net income of $1,500 based on Service Revenue $5,500, Salaries and Wages Expense $2,300, Supplies Expense $1,200, and Utilities Expense $500. In reviewing the statement, you discover the following.

1. Insurance expired during July of $400 was omitted.2. Supplies expense includes $300 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 $280 were not included.5. Services performed but unrecorded totaled $920.

InstructionsPrepare a correct income statement for July 2014.

E3-11 A partial adjusted trial balance of Rooney Company at January 31, 2014, shows the following.

Rooney CompanyAdjusted Trial Balance

January 31, 2014

Debit Credit

Supplies £ 850Prepaid Insurance 2,400Salaries and Wages Payable £ 800Unearned Service Revenue 750Supplies Expense 950Insurance Expense 400Salaries and Wages Expense 2,500Service Revenue 2,000

InstructionsAnswer the following questions, assuming the year begins January 1.

(a) If the amount in Supplies Expense is the January 31 adjusting entry, and £670 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 £3,300 of salaries was paid in January, what was the balance in Salaries and Wages Payable at December 31, 2013?

E3-12 Selected accounts of Welch Company are shown below.

Prepare correct incomestatement.

(LO 2, 5, 6, 7)

Analyze adjusted data.

(LO 4, 5, 6, 7)

Journalize basic transactions and adjusting entries.

(LO 5, 6, 7) Supplies Expense

7/31 800

Supplies Salaries and Wages Payable

7/1 Bal. 1,100 7/31 800 7/31 1,2007/10 200

Accounts Receivable Unearned Service Revenue

7/31 620 7/31 900 7/1 Bal. 1,500 7/20 750

Salaries and Wages Expense Service Revenue

7/15 1,200 7/14 2,0007/31 1,200 7/31 900 7/31 620


Exercises 139

InstructionsAfter 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.)

E3-13 The trial balances before and after adjustment for Matusiak Company at the end of its fi scal year are presented below.

Prepare adjusting entries from analysis of trial balances.

(LO 5, 6, 7)

Matusiak CompanyTrial Balance

August 31, 2014

Before After Adjustment Adjustment

Dr. Cr. Dr. Cr.

Cash €10,400 € 10,400Accounts Receivable 8,800 10,000Supplies 2,300 700Prepaid Insurance 4,000 2,500Equipment 14,000 14,000Accumulated Depreciation—Equipment € 3,600 € 4,900Accounts Payable 5,800 5,800Salaries and Wages Payable –0– 1,100Unearned Rent Revenue 1,500 800Share Capital—Ordinary 12,000 12,000Retained Earnings 3,600 3,600Service Revenue 34,000 35,200Rent Revenue 11,000 11,700Salaries and Wages Expense 17,000 18,100Supplies Expense –0– 1,600Rent Expense 15,000 15,000Insurance Expense –0– 1,500Depreciation Expense –0– 1,300

€71,500 €71,500 €75,100 €75,100

InstructionsPrepare the adjusting entries that were made.

E3-14 The adjusted trial balance for Matusiak Company is given in E3-13.

InstructionsPrepare the income and retained earnings statements for the year and the statement of fi nancial position at August 31.

E3-15 The following data are taken from the comparative statements of fi nancial position of Newman Billiards Club, which prepares its fi nancial statements using the accrual basis of accounting.

December 31 2014 2013

Accounts receivable from members $12,000 $ 9,000Unearned service revenue 17,000 20,000

Members are billed based upon their use of the club’s facilities. Unearned service revenues arise from the sale of gift certifi cates, which members can apply to their future use of club facilities. The 2014 income statement for the club showed that service revenue of $153,000 was recognized during the year.

Instructions(Hint: You will probably fi nd 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 certifi cates outstanding at the end of 2013 were all redeemed.

Prepare fi nancial statements from adjusted trial balance.

(LO 7)

Record transactions onaccrual basis; convert revenue to cash receipts.

(LO 5, 6)



(3) An additional $35,000 worth of gift certifi cates 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 provided to 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.

E3-16 In its fi rst year of operations, Alencar Company recognized Rs30,000 in service revenue, Rs4,800 of which was on account and still outstanding at year-end. The remain-ing Rs25,200 was received in cash from customers.

The company incurred operating expenses of Rs17,000. Of these expenses Rs12,000 was paid in cash; Rs5,000 was still owed on account at year-end. In addition, Alencar prepaid Rs2,600 for insurance coverage that would not be used until the second year of operations.

Instructions(a) Compute Alencar’s fi rst-year cash fl ow from operations.(b) Compute Alencar’s fi rst-year net income under accrual-basis accounting.(c) Which basis of accounting (cash or accrual) provides more useful information for

decision-makers?

*E3-17 Rogert Company has the following balances in selected accounts on December 31, 2014.

Service Revenue $40,000Insurance Expense 2,880Supplies Expense 2,450

All the accounts have normal balances. Rogert 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. Rogert Company paid $2,880 for 12 months of insurance coverage on April 1, 2014.2. On December 1, 2014, Rogert 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 $420 are on

hand.

InstructionsPrepare the adjusting entries needed at December 31, 2014.

*E3-18 At Beloit 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 €2,640 for fi re insurance protection for the year. 10 Paid €1,700 for supplies. 15 Received €6,400 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.

*E3-19 Presented below are the assumptions and principles discussed in this chapter.

1. Full disclosure principle. 4. Time period assumption.2. Going concern assumption. 5. Historical cost principle.3. Monetary unit assumption. 6. Economic entity assumption.

Compute cash fl ow from operations and net income.

(LO 2)

Journalize adjusting entries.

(LO 8)

Journalize transactions and adjusting entries.

(LO 8)

Identify accountingassumptions and principles.

(LO 9)


Exercises 141

InstructionsIdentify 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 fi nancial performance.

_______ (d) Separates fi nancial 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 fi nancial statement users.

*E3-20 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.

InstructionsIn each situation, identify the assumption or principle that has been violated, if any, and discuss what the company should have done.

*E3-21 The following characteristics, assumptions, principles, or constraint guide the IASB when it creates accounting standards.

Relevance Expense recognition principleFaithful representation Time period assumptionComparability Going concern assumptionConsistency Historical cost principleMonetary unit assumption Full disclosure principleEconomic 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 fi nancial

statement users. 5. ________ The practice of preparing fi nancial 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 statement of fi nancial position

at the price that was paid to acquire the item. 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 fi nancial statements.11. ________ Reporting only those things that can be measured in monetary units.12. ________ Dictates that efforts (expenses) be matched with results (revenues).

*E3-22 Net Nanny Software International Inc., headquartered in Vancouver, specializes in Internet safety and computer security products for both the home and commercial markets. In a recent statement of fi nancial position, it reported a defi cit (negative retained earnings) of US$5,678,288. It has reported only net losses since its inception. In spite of these losses, Net Nanny’s ordinary shares have traded anywhere from a high of $3.70 to a low of $0.32 on the Canadian Venture Exchange.

Net Nanny’s fi nancial statements have historically been prepared in Canadian dollars. Recently, the company adopted the U.S. dollar as its reporting currency.

Identify the assumption or principle that has been violated.

(LO 9)

Identity fi nancial accounting concepts and principles.

(LO 9)

Comment on the objectives and qualitative characteristics of accounting information

(LO 9)



P3-1A Joey Cuono started his own consulting fi rm, Cuono Company, on June 1, 2014. The trial balance at June 30 is shown below.

Cuono CompanyTrial BalanceJune 30, 2014

Account Number Debit Credit

101 Cash $ 6,200 112 Accounts Receivable 6,000 126 Supplies 2,000 130 Prepaid Insurance 3,000 157 Equipment 14,400 201 Accounts Payable $ 4,700 209 Unearned Service Revenue 4,000 311 Share Capital—Ordinary 20,000 400 Service Revenue 7,900 726 Salaries and Wages Expense 4,000 729 Rent Expense 1,000

$36,600 $36,600

Prepare adjusting entries, post to ledger accounts, and prepare adjusted trial balance.

(LO 5, 6, 7)

PROBLEMS: SET A

Instructions (a) What is the objective of fi nancial 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 con-

sistently reported losses over the last few years? Include in your answer an as-sessment 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 fi nancial statements. Include in your answer an assessment of the comparability of the information.

*E3-23 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 fi nancing 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 scientifi c fi ndings 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 scientifi c fi ndings, 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 prin-ciples. Why do we need to look at some accounting rules? What they need to realize is that we have scientifi c 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 inves-

tors 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 fi nancial reporting guidelines?

Comment on the objectives and qualitative characteris-tics of fi nancial reporting.

(LO 9)


Problems: Set A 143

In addition to those accounts listed on the trial balance, the chart of accounts for Cuono 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 $1,100.2. 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. $2,500 of unearned service revenue is recognized for services performed at the end of

the month.5. Salaries of $1,600 are accrued at June 30.6. The equipment has a 4-year life with no residual value. It is being depreciated at $300

per month for 48 months.7. Invoices representing $2,100 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.

P3-2A Lazy River Resort opened for business on June 1 with eight air-conditioned units. Its trial balance before adjustment on August 31 is as follows.

Lazy River Resort, Inc.Trial Balance

August 31, 2014


101 Cash € 19,600 126 Supplies 3,300 130 Prepaid Insurance 6,000 140 Land 25,000 143 Buildings 125,000 157 Equipment 26,000 201 Accounts Payable € 6,500 208 Unearned Rent Revenue 7,400 275 Mortgage Payable 80,000 311 Share Capital—Ordinary 100,000 332 Dividends 5,000 429 Rent Revenue 80,000 622 Maintenance and Repairs Expense 3,600 726 Salaries and Wages Expense 51,000 732 Utilities Expense 9,400

€273,900 €273,900

In addition to those accounts listed on the trial balance, the chart of accounts for Lazy River Resort also contains the following accounts and account numbers: No. 112 Accounts Receivable, No. 144 Accumulated Depreciation—Buildings, No. 158 Accumulated Depreciation—Equipment, No. 212 Salaries and Wages Payable, No. 230 Interest Payable, No. 631 Supplies Expense, No. 711 Depreciation Expense, No. 718 Interest Expense, and No. 722 Insurance Expense.

Other data:

1. Insurance expires at the rate of €400 per month.2. A count on August 31 shows €900 of supplies on hand.3. Annual depreciation is €4,500 on buildings and €2,400 on equipment.4. Unearned rent revenue of €4,100 was recognized for services performed prior to August 31.5. Salaries of €400 were unpaid at August 31.

(c) Adj. trial balance $40,750

Prepare adjusting entries, post, and prepare adjusted trial balance, and fi nancial statements.

(LO 5, 6, 7)



6. Rentals of €3,700 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.)

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 a retained earnings statement for the 3 months ending

August 31 and a statement of fi nancial position as of August 31.

P3-3A Costello Advertising Agency Inc. was founded by Pat Costello in January of 2013. Presented below are both the adjusted and unadjusted trial balances as of December 31, 2014.

Costello Advertising Agency, Inc.Trial Balance

December 31, 2014

Unadjusted Adjusted

Dr. Cr. Dr. Cr.

Cash $ 11,000 $ 11,000Accounts Receivable 20,000 23,500Supplies 8,600 5,000Prepaid Insurance 3,350 2,500Equipment 60,000 60,000Accumulated Depreciation—Equipment $ 28,000 $ 33,000Accounts Payable 5,000 5,000Interest Payable –0– 150Notes Payable 5,000 5,000Unearned Service Revenue 7,200 5,600Salaries and Wages Payable –0– 1,300Share Capital—Ordinary 20,000 20,000Retained Earnings 5,500 5,500Dividends 12,000 12,000Service Revenue 58,600 63,700Salaries and Wages Expense 10,000 11,300Insurance Expense 850Interest Expense 350 500Depreciation Expense 5,000Supplies Expense 3,600Rent Expense 4,000 4,000

$129,300 $129,300 $139,250 $139,250

Instructions(a) Journalize the annual adjusting entries that were made.(b) Prepare an income statement and a retained earnings statement for the year ending

December 31, 2014, and a statement of fi nancial position 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 $14,500 in salaries in 2014, what was the balance in Salaries

and Wages Payable on December 31, 2013?

P3-4A A review of the ledger of Bellingham 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 £800 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.

2. Unearned Rent Revenue £324,000. The company began subleasing offi ce 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.

(c) Adj. trial balance €280,325

(d) Net income €17,475Ending retained earnings €12,475

Total assets €203,275

Prepare adjusting entries and fi nancial statements.

(LO 5, 6, 7)

(b) Net income $38,450 Ending retained earnings $31,950 Total assets $69,000

(c) (1) 6% (2) $4,500

Preparing adjusting entries.

(LO 5, 6)1. Salaries and wages

expense £2,200

2. Rent revenue £74,000


Problems: Set A 145

Term Number of Date (in months) Monthly Rent Leases

Nov. 1 6 £4,000 5 Dec. 1 6 £8,500 4

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.

Number of Magazine Contract Date Amount Issues

A650 May 1 £6,000 12 B974 Oct. 1 £9,600 24

The fi rst advertisement runs in the month in which the contract is signed.4. Notes Payable £100,000. This balance consists of a note for one year at an annual interest

rate of 9%, dated June 1.

InstructionsPrepare the adjusting entries at December 31, 2014. (Show all computations.)

P3-5A On September 1, 2014, the account balances of Beck Equipment Repair, Inc. were as follows.

No. Debit No. Credit

101 Cash £ 4,880 158 Accumulated Depreciation—Equipment £ 2,100112 Accounts Receivable 3,520 201 Accounts Payable 3,400126 Supplies 2,000 209 Unearned Service Revenue 1,400157 Equipment 18,000 212 Salaries and Wages Payable 500 311 Share Capital—Ordinary 10,000 320 Retained Earnings 11,000

£28,400 £28,400

During September, the following summary transactions were completed.

Sept. 8 Paid £1,700 for salaries due employees, of which £1,200 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 £1,050. 27 Performed services on account and billed customers for services provided £1,600. 29 Received £750 from customers for future service.

Adjustment data consist of:

1. Supplies on hand £1,700.2. Accrued salaries payable £400.3. Depreciation is £140 per month.4. Unearned service revenue of £1,450 is recognized for services performed.

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 addi-

tional accounts: No. 400 Service Revenue, No. 631 Supplies Expense, No. 711 Depre-ciation 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 a retained earnings statement for September and a

statement of fi nancial position at September 30.

3. Advertising expense £5,200

4. Interest expense£5,250

Journalize transactions and follow through accounting cycle to preparation offi nancial statements.

(LO 5, 6, 7)

(d) Trial balance £33,350(f) Adj. trial balance £33,890(g) Net income £1,660 Ending retained earnings £12,660 Total assets £26,860



P3-1B Lira Lopez started her own consulting fi rm, Lira Consulting, Inc. on May 1, 2014. The trial balance at May 31 is as follows.

Lira Consulting, Inc.Trial BalanceMay 31, 2014


101 Cash R$ 7,700 112 Accounts Receivable 4,000 126 Supplies 1,500 130 Prepaid Insurance 2,400 157 Equipment 12,000 201 Accounts Payable R$ 4,500 209 Unearned Service Revenue 2,600 311 Share Capital—Ordinary 16,000 400 Service Revenue 8,500 726 Salaries and Wages Expense 3,000 729 Rent Expense 1,000

R$31,600 R$31,600

In addition to those accounts listed on the trial balance, the chart of accounts for Lira Con-sulting 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.

Prepare adjusting entries, post to ledger accounts, and prepare an adjusted trial balance.

(LO 5, 6, 7)

*P3-6A Alpha Graphics Company, Inc. was organized on January 1, 2014. At the end of the fi rst 6 months of operations, the trial balance contained the accounts shown below.

Debit Credit

Cash $ 8,400 Notes Payable $ 20,000Accounts Receivable 14,000 Accounts Payable 9,000Equipment 45,000 Share Capital—Ordinary 22,000Insurance Expense 2,880 Service Revenue 58,280Salaries and Wages Expense 30,000Supplies Expense 3,900Advertising Expense 1,900Rent Expense 1,500Utilities Expense 1,700

$109,280 $109,280

Analysis reveals the following additional data.

1. The $3,900 balance in Supplies Expense represents supplies purchased in January. At June 30, $680 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, service revenue of

$1,100 is still not performed for the customer.5. Depreciation is $2,250 per year.

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 a retained earnings statement for the 6 months

ended June 30 and a statement of fi nancial position at June 30.

Prepare adjusting entries, adjusted trial balance, and fi nancial statements using appendix.

(LO 5, 6, 7, 8)

(b) Adj. trial balance $111,155(c) Net income $16,025 Ending retained earnings

$16,025 Total assets $68,875

PROBLEMS: SET B


Problems: Set B 147

Other data:

1. R$500 of supplies have been used during the month.2. Utilities expense incurred but not paid on May 31, 2014, R$200.3. The insurance policy is for 2 years.4. R$1,000 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. Lira Consulting has two

employees, who are paid R$500 each for a 5-day work week.6. The offi ce equipment has a 5-year life with no residual value. It is being depreciated at

R$200 per month for 60 months.7. Invoices representing R$1,400 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.

P3-2B The Badger Motel, Inc. opened for business on May 1, 2014. Its trial balance before adjustment on May 31 is as follows.

Badger Motel, Inc.Trial BalanceMay 31, 2014


101 Cash $ 2,500 126 Supplies 1,520 130 Prepaid Insurance 2,400 140 Land 14,000 141 Buildings 58,000 157 Equipment 15,000 201 Accounts Payable $ 4,800 208 Unearned Rent Revenue 3,300 275 Mortgage Payable 38,000 311 Share Capital—Ordinary 40,000 429 Rent Revenue 12,300 610 Advertising Expense 780 726 Salaries and Wages Expense 3,300 732 Utilities Expense 900

$98,400 $98,400

In addition to those accounts listed on the trial balance, the chart of accounts for Badger Motel, Inc. also contains the following accounts and account numbers: No. 142 Accumu-lated Depreciation—Buildings, No. 158 Accumulated Depreciation—Equipment, No. 212 Salaries and Wages Payable, No. 230 Interest Payable, No. 631 Supplies Expense, No. 711 Depreciation 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 $350 of unused supplies on May 31.3. Annual depreciation is $2,640 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 recognized for services performed.6. Salaries of $750 are accrued and unpaid at May 31.

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) Adj. trial balance R$34,000

Prepare adjusting entries, post, and prepare adjusted trial balance, and fi nancial statements.

(LO 5, 6, 7)



(c) Prepare an adjusted trial balance on May 31.(d) Prepare an income statement and a retained earnings statement for the month of May

and a statement of fi nancial position at May 31.

P3-3B Lausanne Co., Inc. was organized on July 1, 2014. Quarterly fi nancial statements are prepared. The unadjusted and adjusted trial balances as of September 30 are shown below.

Lausanne Co., Inc.Trial Balance

September 30, 2014

Unadjusted Adjusted

Dr. Cr. Dr. Cr.

Cash CHF 8,700 CHF 8,700Accounts Receivable 10,400 11,500Supplies 1,900 650Prepaid Rent 2,200 1,200Equipment 20,000 20,000Accumulated Depreciation—Equipment CHF –0– CHF 1,125Notes Payable 10,000 10,000Accounts Payable 3,200 3,200Salaries and Wages Payable –0– 725Interest Payable –0– 100Unearned Rent Revenue 1,900 1,050Share Capital—Ordinary 22,000 22,000Dividends 1,000 1,000Service Revenue 16,800 17,900Rent Revenue 1,710 2,560Salaries and Wages Expense 8,000 8,725Rent Expense 1,900 2,900Depreciation Expense 1,125Supplies Expense 1,250Utilities Expense 1,510 1,510Interest Expense 100

CHF55,610 CHF55,610 CHF58,660 CHF58,660

Instructions(a) Journalize the adjusting entries that were made.(b) Prepare an income statement and a retained earnings statement for the 3 months end-

ing September 30 and a statement of fi nancial position at September 30.(c) If the note bears interest at 12%, how many months has it been outstanding?

P3-4B A review of the ledger of Khan Company at December 31, 2014, produces the following data pertaining to the preparation of annual adjusting entries.

1. Prepaid Insurance €9,300. The company has separate insurance policies on its build-ings and its motor vehicles. Policy B4564 on the building was purchased on April 1, 2013, for €6,000. The policy has a term of 3 years. Policy A2958 on the vehicles was purchased on January 1, 2014, for €4,800. This policy has a term of 2 years.

2. Unearned Rent Revenue €429,000. The company began subleasing offi ce 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.

Term Number of Date (in months) Monthly Rent Leases

Nov. 1 9 €5,000 5Dec. 1 6 8,500 4

3. Notes Payable €120,000. This balance consists of a note for 9 months at an annual interest rate of 9%, dated November 1.

(c) Adj. trial balance $99,875(d) Net income $6,675

Ending retained earnings $6,675Total assets $91,705

Prepare adjusting entriesand fi nancial statements.

(LO 5, 6, 7)

(b) Net income CHF4,850 Ending retained earnings

CHF3,850 Total assets CHF40,925Prepare adjusting entries

(LO 5, 6)

1. Insurance expense €4,400

2. Rent revenue €84,000

3. Interest expense €1,800


Continuing Cookie Chronicle 149

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 €640 each per week, and three employees earn €500 each per week. Assume December 31 is a Wednesday. Employees do not work weekends. All employees worked the last 3 days of December.

InstructionsPrepare the adjusting entries at December 31, 2014.

P3-5B On November 1, 2014, the account balances of Samone Equipment Repair, Inc. were as follows.

No. Debit No. Credit

101 Cash $ 2,400 158 Accumulated Depreciation—Equipment $ 2,000112 Accounts Receivable 4,450 201 Accounts Payable 2,600126 Supplies 1,800 209 Unearned Service Revenue 1,360157 Equipment 16,000 212 Salaries and Wages Payable 700 311 Share Capital—Ordinary 10,000 320 Retained Earnings 7,990

$24,650 $24,650

During November, the following summary transactions were completed.

Nov. 8 Paid $1,500 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 $500. 25 Paid salaries $1,500. 27 Performed services on account and billed customers for services provided $1,900. 29 Received $350 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. Unearned service revenue of $1,380 is recognized for services performed.

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. 400 Service Revenue, No. 631 Supplies Expense, No. 711 Depreciation 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 a retained earnings statement for November and a

statement of fi nancial position at November 30.

4. Salaries and wagesexpense €2,820

Journalize transactions and follow through accounting cycle to preparation of fi nancial statements.

(LO 5, 6, 7)

(d) Trial balance $29,300(f) Adj. trial balance $29,850(g) Net income $1,930

Ending retained earnings $9,920Total assets $23,200

(Note: This is a continuation of the Cookie Chronicle from Chapters 1–2. Use the informa-tion from the previous chapters and follow the instructions on the next page 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 fi rst month of business. Natalie, too, would like to know if the company has been profi table or not during November.

CONTINUING COOKIE CHRONICLE

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Financial Reporting and Analysis

Financial Reporting Problem: Samsung Electronics Co., Ltd.

BYP3-1 The fi nancial statements of Samsung are presented in Appendix A at the end of this text-book. The complete annual report, including the notes to the fi nancial statements, is available in the Investor Relations section of the company’s website, www.samsung.com.

Instructions(a) Using the consolidated fi nancial statements and related information, identify items that may

result in adjusting entries for prepayments.(b) Using the consolidated fi nancial statements and related information, identify items that may

result in adjusting entries for accruals.

Comparative Analysis Problem: Nestlé S.A. vs. Zetar plc

BYP3-2 Nestlé’s fi nancial statements are presented in Appendix B. Financial statements for Zetar are presented in Appendix C.

InstructionsBased on information contained in these fi nancial statements, determine the following for each company.

(a) Net increase (decrease) in property, plant, and equipment (net) for the most recent fi scal year shown.(b) Increase (decrease) in marketing and administration expenses (Nestlé) and increase (decrease)

in administrative expenses (Zetar) for the most recent fi scal year shown.

Broadening Your PERSPECTIVE

Natalie realizes that in order to determine Cookie Creations’ income, she must fi rst 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 ex-tended 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 fi rst-grade students how to make holiday 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 offi ce, 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.

InstructionsUsing 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.


(c) Increase (decrease) in non-current liabilities for the most recent fi scal year shown.(d) Increase (decrease) in profi t for the most recent fi scal year shown.(e) Increase (decrease) in cash and cash equivalents for the most recent fi scal year shown.

Real-World Focus

BYP3-3 No fi nancial decision-maker should ever rely solely on the fi nancial information reported in the annual report to make decisions. It is important to keep abreast of fi nancial news. This activity demonstrates how to search for fi nancial news on the Internet.

Address: http://biz.yahoo.com/i, or go to www.wiley.com/college/weygandt

Steps1. Type in either Carrefour, Marks & Spencer, or Wal-Mart.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 fi nancial planner and that one of your clients owns shares in

the company. Write a brief memo to your client summarizing the article and explaining the implications of the article for their investment.

Broadening Your Perspective 151

Revenues Rent revenue $88,000Operating expenses Advertising $ 5,200 Salaries and wages 28,800 Utilities 750 Depreciation 800 Maintenance and repairs 4,000

Total operating expenses 39,550

Net income $48,450

Happy Trails Park, Inc.Income Statement

For the Quarter Ended March 31, 2014

Critical Thinking

Decision-Making Across the Organization

BYP3-4 Happy Trails Park, Inc. was organized on April 1, 2013, by Alicia Henry. Alicia is a good manager but a poor accountant. From the trial balance prepared by a part-time bookkeeper, Alicia prepared the following income statement for the quarter that ended March 31, 2014.

Alicia 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 fi rst look at the trial balance. In addition to the account balances reported above in the in-come statement, the ledger contains the following additional selected balances at March 31, 2014.

Supplies $ 6,200Prepaid Insurance 7,500Notes Payable 12,000



You then make inquiries and discover the following.

1. Rent revenue includes advanced rentals for summer occupancy $14,000.2. There were $1,450 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, $130;

repairs made March 10, $260; and utilities, $120.5. 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.

InstructionsWith the class divided into groups, answer the following.

(a) Prepare a correct income statement for the quarter ended March 31, 2014.(b) Explain to Alicia the IFRSs that she did not recognize in preparing her income statement and

their effect on her results.

Communication Activity

BYP3-5 In reviewing the accounts of Maribeth Co. at the end of the year, you discover that adjusting entries have not been made.

InstructionsWrite a memo to Maribeth Danon, the owner of Maribeth 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

BYP3-6 Watkin Company is a pesticide manufacturer. Its sales declined greatly this year due to the passage of legislation outlawing the sale of several of Watkin’s chemical pesticides. In the coming year, Watkin will have environmentally safe and competitive chemicals to replace these discontin-ued products. Sales in the next year are expected to greatly exceed any prior year’s. The decline in sales and profi ts appears to be a one-year aberration. But even so, the company president fears a large dip in the current year’s profi ts. He believes that such a dip could cause a signifi cant drop in the market price of Watkin’s ordinary shares and make the company a takeover target. To avoid this possibility, the company president calls in Diane Leno, 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 Diane, “We need the revenues this year, and next year can easily absorb expenses deferred from this year. We can’t let our share price be hammered down!” Diane 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. Diane 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) Diane’s dating the

adjusting entries December 31?(c) Can Diane accrue revenues and defer expenses and still be ethical?

Answers to Chapter Questions

Answers to Insight and Accounting Across the Organization Questions

p. 100 Cooking the Books? Q: What motivates sales executives and fi nance and accounting exec-utives 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


Another Perspective 153

and fi nance are very aware of the earnings targets of fi nancial analysts and investors. If they fail to meet these targets, the company’s share price will fall. As a result of these pressures, executives sometimes knowingly engage in unethical efforts to misstate revenues. p. 108 Turning Gift Cards into Revenue Q: Suppose that Robert Jones purchases a €100 gift card at Carrefour (FRA) on December 24, 2013, and gives it to his wife, Mary Jones, on Decem-ber 25, 2013. On January 3, 2014, Mary uses the card to purchase €100 worth of CDs. When do you think Carrefour should recognize revenue and why? A: According to the revenue recognition principle, companies should recognize revenue when the performance obligation is satisfi ed. In this case, revenue is not recognized until Carrefour provides the goods. Thus, when Carrefour receives cash in exchange for the gift card on December 24, 2013, it should recognize a liability, Unearned Revenue, for €100. On January 3, 2014, when Mary Jones exchanges the card for merchan-dise, Carrefour should recognize revenue and eliminate €100 from the balance in the Unearned Revenue account.p. 114 Got Junk? Q: What accounting issue might this cause for companies? A: The statement of fi nancial position should provide a fair representation of what a company owns and what it owes. If signifi cant obligations of the company are not reported on the statement of fi nancial position, 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 doesn’t seem reasonable to not accrue for environmental costs. Recognition of these liabilities provides a more accurate picture of the company’s fi nancial posi-tion. It also has the potential to improve the environment. As companies are forced to report these amounts on their fi nancial statements, they will start to look for more effective and effi cient 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 2 $600) 8. c 9. a 10. c 11. a 12. b 13. b 14. c *15. a *16. c *17. c

All companies struggle to determine the proper revenues and expenses to use in measuring net income, so timing is everything. 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. The objective of the conceptual framework project is to lead to standards that are more principles-based and internally consistent, which will in turn lead to the most useful fi nancial reporting.

Key Points• Like IFRS, companies applying GAAP use accrual-basis accounting to ensure that they record

transactions that change a company’s fi nancial statements in the period in which events occur.

• Similar to IFRS, cash-basis accounting is not in accordance with GAAP.

• GAAP also divides the economic life of companies into artifi cial time periods. Under both GAAP and IFRS, this is referred to as the time period assumption. GAAP requires that companies present a complete set of fi nancial statements, including comparative information annually.

• GAAP has more than 100 rules dealing with revenue recognition. Many of these rules are industry-specifi c. Revenue recognition under IFRS is determined primarily by a single standard, IAS 18. Despite this large disparity in the detailed guidance devoted to revenue recognition, the general revenue recognition principles required by IFRS that are used in this textbook are similar to those under GAAP.

Another Perspective



• 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 this requirement.

• Under IFRS, revaluation to fair value of items such as land and buildings is permitted. This is not permitted under GAAP.

• The form and content of fi nancial statements are very similar under GAAP and IFRS. Any signifi -cant differences will be discussed in those chapters that address specifi c fi nancial statements.

• Revenue recognition fraud is a major issue in U.S. fi nancial reporting. The same situation exists for most other countries as well.

• As indicated above, both the IASB and FASB are working together on a common conceptual framework. Some of the major issues that are being addressed are:

♦ What are the qualitative characteristics that make accounting information useful?

♦ What is the primary objective of fi nancial reporting?

♦ What basis should be used to measure and report, that is, should a historical cost or fair value approach be used?

♦ What criteria should be used to determine when revenue should be recognized and when expenses have been incurred?

♦ What guidelines should be established for disclosing fi nancial information?

• 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 in-come is not used this way under GAAP. Instead, under GAAP income refers to the net difference between revenues and expenses. Expenses under IFRS 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 defi nes each separately.

Looking to the FutureAs this textbook is being written, the IASB and FASB are close to completing a joint project on revenue recognition. The purpose of this project is to develop comprehensive guidance on when to recognize revenue. This approach focuses on changes in assets and liabilities as the basis for rev-enue recognition. It is hoped that this approach will lead to more consistent accounting in this area. For more on this topic, see www.fasb.org/project/revenue_recognition.shtml.

GAAP Practice

GAAP Self-Test Questions1. GAAP:

(a) provides the same type of guidance as IFRS for revenue recognition.(b) provides only general guidance on revenue recognition, compared to the detailed guidance

provided by IFRS.(c) allows revenue to be recognized when a customer makes an order.(d) requires that revenue not be recognized until cash is received.

2. Which of the following statements is false?(a) GAAP employs the time period assumption.(b) GAAP employs accrual accounting.(c) GAAP requires that revenues and costs must be capable of being measured reliably.(d) GAAP 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 satisfi ed.(b) revenue recognition places more emphasis on when revenue is realized.(c) revenue recognition places more emphasis on when changes occur in related expenses.(d) revenue is no longer recorded unless cash has been received.


Another Perspective 155

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, fi rms do not engage in the closing process.(d) IFRS has fewer standards than GAAP that address revenue recognition.

5. Accrual-basis accounting:(a) is optional under GAAP.(b) results in companies recording transactions that change a company’s fi nancial 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 GAAP conceptual framework.

GAAP Exercises

GAAP3-1 Why might IFRS revalue land and buildings whereas under GAAP this practice is not permissible?

GAAP3-2 Under GAAP, do the defi nitions of revenues and expenses include gains and losses? Explain.

GAAP Financial Reporting Problem: Tootsie Roll Industries, Inc.GAAP3-3 The fi nancial statements of Tootsie Roll are presented in Appendix D. The company’s complete annual report, including the notes to its fi nancial statements, is available at www.tootsie.com.

Instructions

Visit Tootsie Roll’s corporate website and answer the following questions from Tootsie Roll’s 2010 annual report.

(a) Using the fi nancial statements and related information, identify items that may result in adjust-ing entries for prepayments.

(b) Using the fi nancial statements and related information, identify items that may result in adjusting entries for accruals.

Answers to GAAP Self-Test Questions1. a 2. d 3. a 4. c 5. b

✔ The Navigator

✔ Remember to go back to The Navigator box on the chapter opening page and check off your completed work.


Chapter 3: Adjusting the Accounts

Documents

Transcript of Chapter 3: Adjusting the Accounts