Chapter 3
Adjusting Accounts and Preparing Financial Statements
QUESTIONS 1.
The cash basis of accounting reports revenues when cash is received while the accrual basis reports revenues when they are earned. The cash basis reports expenses when cash is paid while the accrual basis reports expenses when they are incurred and matched with revenues they generated.
The accrual basis of accounting generally provides a better indication of company performance and financial condition than does the cash basis. Also, the accrual basis increases the comparability of financial statements from one period to the next. Thus, business decision makers generally prefer the accrual basis.
Businesses that have major seasonal variations in sales are most likely to select the natural business year as the fiscal year.
A prepaid expense is an item paid for in advance of receiving its benefits. As such, it is reported as an asset on the balance sheet.
Long-term tangible plant assets such as equipment, buildings, and machinery lead to adjustments for depreciation. Generally, land is the only long-term tangible plant asset that does not require depreciation.
The Accumulated Depreciation contra account is used for depreciation. It provides financial statement users with additional information about the relative age of the assets. Without the contra account information, the reader would not be able to tell whether the assets are new or in need of replacement.
Unearned revenue refers to cash received in advance of providing products and services. Another name for unearned revenue is deferred revenue. It is reported as a liability on the balance sheet.
Accrued revenue is revenue that is earned but is not yet received in cash (and/or other assets) and the customer has not been billed prior to the end of the period. Therefore, end-of-period adjustments are made to record accrued revenue. Examples are interest income that has been earned but not collected and revenues from services performed that are neither collected nor billed.
2.
3. 4. 5.
6.
7.
8.
9.A If prepaid expenses are initially recorded with debits to expense accounts, then the
prepaid expenses asset accounts are debited in the adjusting entries.
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10. For Best Buy, all of the accounts under the category of Property and Equipment
(except for Land), require adjusting entries. The expense related to the depreciation expense account would be understated on the income statement if Best Buy fails to adjust these asset accounts. If the adjusting entries are not made, net income would be overstated. Note: Students might also correctly identify accounts receivable, goodwill, and tradenames as needing adjustment. 11. Circuit City must make adjusting entries to Prepaid expenses and other current
assets; Deferred income taxes; Accrued expenses and other current liabilities; Accrued income taxes; and possibly other assets and liabilities such as Receivables for bad debts. (It is also possible that Circuit City would need to adjust Goodwill and Other intangible assets.) 12. RadioShack would need to debit interest receivable and credit interest revenue. 13. The Accrued Wages Expense would be reported as part of ―Accrued Expenses‖ on
Apple’s balance sheet. QUICK STUDIES Quick Study 3-1 (15 minutes)
Cash Accounting
Revenues (cash receipts) ...................................................... Expenses (cash payments: $37,500 - $6,000 + $3,250) ...... Net income .............................................................................
Accrual Accounting
Revenues (earned) ................................................................ Expenses (incurred) .............................................................. Net income ..............................................................................
Quick Study 3-2 (10 minutes)
a. AE Accrued expenses b. PE Prepaid expenses c. UR Unearned revenues
d. PE Prepaid expenses (Depreciation) e. AR Accrued revenues
$52,000 34,750 $17,250 $60,000 37,500 $22,500 ?McGraw-Hill Companies, 2009 120
Fundamental Accounting Principles, 19th Edition
Quick Study 3-3 (20 minutes) Accounts Debited and Credited Financial Statement a. Debit Unearned Revenue Balance Sheet Credit Revenue Earned Income Statement b. Debit Wages Expense Income Statement Credit Wages Payable Balance Sheet c. Debit Accounts Receivable Balance Sheet Credit Revenue Earned Income Statement d. Debit Insurance Expense Income Statement Credit Prepaid Insurance Balance Sheet e. Debit Depreciation Expense Income Statement Credit Accumulated Depreciation Balance Sheet
Quick Study 3-4 (15 minutes)
a. Insurance Expense ....................................................... 3,000 Prepaid Insurance .................................................
To record 6-month insurance coverage expired.
3,000
b. Supplies Expense ......................................................... Supplies ..................................................................
To record supplies used during the year. ($900 + $4,000 – [?] = $750)
4,150
4,150
Quick Study 3-5 (15 minutes)
a. Depreciation Expense—Equipment ............................ Accumulated Depreciation—Equipment .............
To record depreciation expense for the year. ($45,000 - $3,000) / 5 years = $8,400
8,400
8,400
b. No depreciation adjustments are made for land as it is expected to last indefinitely.
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Quick Study 3-6 (10 minutes)
Salaries Expense ........................................................... Salaries Payable ....................................................
To record salaries incurred but not yet paid. [One student earns $100 x 4 days, Monday through Thursday]
400
400
Quick Study 3-7 (15 minutes)
a. Unearned Revenue ........................................................ 22,500 Legal Revenue .......................................................
To recognize legal revenue earned (30,000 x 3/4).
22,500
b. Unearned Subscription Revenue ................................ Subscription Revenue ...........................................
To recognize subscription revenue earned. [100 x ($24 / 12 months) x 6 months]
1,200
1,200
Quick Study 3-8 (15 minutes)
Adjusting entry 1. Accrue salaries expense
2. Adjust the Unearned Services Revenue account to recognize earned revenue
Debit e a
Credit g f
3. Record the earning of services revenue for which b f cash will be received the following period
Quick Study 3-9 (10 minutes)
The answer is a.
Explanation The debit balance in Prepaid Insurance was reduced by $400, implying a $400 debit to Insurance Expense. The credit balance in Interest Payable increased by $800, implying an $800 debit to Interest Expense.
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Fundamental Accounting Principles, 19th Edition
Quick Study 3-10 (15 minutes)
The answer is 2.
Explanation
Insurance premium error Understates expenses (and overstates assets) by .......... $1,600
Accrued salaries error Understates expenses (and understates liabilities) by .... 1,000
The collective effects from this company’s errors follow:
Understates expenses by ..................................................... $2,600 Overstates assets by ............................................................. $1,600 Understates liabilities by ...................................................... $1,000
Quick Study 3-11 (10 minutes)
Profit margin = $78,750 / $630,000 = 12.5%
Interpretation: For each dollar that Miller Company records as revenue, it earns 12.5 cents in net income. Miller’s 12.5% is markedly lower than competitors’ average profit margin of 15%—it must improve performance.
Quick Study 3-12A (5 minutes)
The answer is c.
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