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C H A P T E R

3 Measuring Business Income I ncome, or earnings, is the most important measure of a com-pany’s success or failure. Thus, the incentive to manage, or mis- state, earnings by manipulating the numbers can be powerful, and

because earnings are based on estimates, manipulation can be easy.

For these reasons, ethical behavior is extremely important when

measuring business income.

L E A R N I N G O B J E C T I V E S

LO1 Define net income, and explain the assumptions underlying income measurement and their ethical application. (pp. 100–104)

LO2 Define accrual accounting, and explain how it is accomplished. (pp. 104–106)

LO3 Identify four situations that require adjusting entries, and illustrate typical adjusting entries. (pp. 107–116)

LO4 Prepare financial statements from an adjusted trial balance. (pp. 116–119)

LO5 Use accrual-based information to analyze cash flows. (pp. 119–120)

Making a Statement

Revenues

– Expenses

= Net Income

INCOME STATEMENT

STATEMENT OF OWNER’S EQUITY

Beginning Balance

+ Net Income

– Withdrawals

= Ending Balance

BALANCE SHEET Assets Liabilities

Owner’s Equity

A = L + OE

STATEMENT OF CASH FLOWS

= Ending Cash Balance

Operating activities + Investing activities + Financing activities = Change in Cash

+ Beginning Balance

Adjusting entries affect the balance sheet and income statement but not the statement of cash flows.

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� What assumptions must Reliable Answering Service make to account for transactions that span accounting periods?

� How does Reliable assign its revenues and expenses to the proper accounting period so that net income is properly measured?

� Why are the adjustments that these transactions require important to Reliable’s financial performance?

DECISION POINT � A USER’S FOCUS RELIABLE ANSWERING SERVICE

Reliable Answering Service takes telephone messages for doctors, lawyers, and other professionals and relays them immediately when they involve an emergency. At the end of any accounting period, Reliable has many transactions that will affect future periods. Exam- ples appear in the company’s trial balance on the following page. They include office supplies and prepaid expenses, which, though paid in the period just ended, will benefit future periods and are there- fore recorded as assets. Another example is unearned revenue, which represents receipts for services the company will not perform and earn until a future period. If prepaid expenses and unearned revenue are not accounted for properly at the end of a period, the company’s income will be misstated. Similar misstatements can occur when a company fails to record (accrue) expenses that it incurred or revenue that it has earned but not yet received. Knowing the answers to the questions at right will help prevent such misstatements.

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Profitability Measurement: Issues and Ethics

LO1 Define net income, and explain the assumptions under- lying income measurement and their ethical application.

As you know, profitability and liquidity are the two major goals of a business. For a business to succeed, or even to survive, it must earn a profit. Profit, however, means different things to different people. Accountants prefer to use the term net income because it can be precisely defined from an accounting point of view as the net increase in owner’s equity that results from a company’s operations.

Net income is reported on the income statement, and management, owners, and others use it to measure a company’s progress in meeting the goal of profitabil- ity. Readers of income statements need to understand what net income means and be aware of its strengths and weaknesses as a measure of a company’s performance.

Net Income Net income is accumulated in the owner’s Capital account. In its simplest form, it is measured as the difference between revenues and expenses when revenues exceed expenses:

Net Income � Revenues � Expenses

When expenses exceed revenues, a net loss occurs. Revenues are increases in owner’s equity resulting from selling goods, render-

ing services, or performing other business activities. When a business delivers a product or provides a service to a customer, it usually receives cash or is prom- ised that it will receive cash in the near future. The amount of cash promised is recorded in either Accounts Receivable or Notes Receivable. The total of these accounts and the total cash received from customers in an accounting period are the company’s revenues for that period.

i p i r a t

Study Note The essence of revenue is that something has been earned through the sale of goods or services. That is why cash received through a loan does not constitute revenue.

100 CHAPTER 3 Measuring Business Income

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Profitability Measurement: Issues and Ethics 101

Expenses are decreases in owner’s equity resulting from the cost of selling goods or rendering services and the cost of the activities necessary to carry on a business, such as attracting and serving customers. In other words, expenses are the cost of the goods and services used in the course of earning revenues. Exam- ples include salaries expense, rent expense, advertising expense, utilities expense, and depreciation (allocation of cost) of a building or office equipment. These expenses are often called the cost of doing business or expired costs.

Not all increases in owner’s equity arise from revenues, nor do all decreases in owner’s equity arise from expenses. Owner’s investments increase owner’s equity but are not revenues, and withdrawals decrease owner’s equity but are not expenses.

Income Measurement Assumptions Users of financial reports should be aware that estimates and assumptions play a major role in the measurement of net income and other key indicators of perfor- mance. The management of Netflix, the online movie rental company, acknowl- edges this in its annual report, as follows:

The preparation of . . . financial statements in conformity with generally accepted accounting principles in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, . . . and the reported amount of revenues and expenses.1

The major assumptions made in measuring business income have to do with con- tinuity, periodicity, and matching.

Continuity Measuring business income requires that certain expense and reve- nue transactions be allocated over several accounting periods. Choosing the num- ber of accounting periods raises the issue of continuity. What is the expected life of the business? Many businesses last less than five years, and in any given year, thousands of businesses go bankrupt. The majority of companies present annual financial statements on the assumption that the business will continue to oper- ate indefinitely—that is, that the company is a going concern. The continuity assumption is as follows:

Unless there is evidence to the contrary, the accountant assumes that the business will continue to operate indefinitely.

Justification for all the techniques of income measurement rests on the assumption of continuity. Consider, for example, the value of assets on the bal- ance sheet. The continuity assumption allows the cost of certain assets to be held on the balance sheet until a future accounting period, when the cost will become an expense on the income statement.

When a firm is facing bankruptcy, the accountant may set aside the assump- tion of continuity and prepare financial statements based on the assumption that the firm will go out of business and sell all of its assets at liquidation value—that is, for what they will bring in cash.

Periodicity Measuring business income requires assigning revenues and expenses to a specific accounting period. However, not all transactions can be eas- ily assigned to specific periods. For example, when a company purchases a build- ing, it must estimate the number of years the building will be in use. The portion of the cost of the building that is assigned to each period depends on this estimate and requires an assumption about periodicity. The assumption is as follows:

Although the lifetime of a business is uncertain, it is nonetheless useful to estimate the business’s net income in terms of accounting periods.

g b t p a

Study Note The primary purpose of an expense is to generate revenue.

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102 CHAPTER 3 Measuring Business Income

Study Note Accounting periods are of equal length so that one period can be compared with the next.

FOCUS ON BUSINESS PRACTICE

Fiscal Years Vary

The fiscal years of many schools and governmental agen- cies end on June 30 or September 30. The table at the right shows the last month of the fiscal year of some well-known companies.

Company Last Month of Fiscal Year

Apple Computer September Caesars World July Fleetwood Enterprises April H.J. Heinz March Kelly Services December MGM-UA Communications August Toys “R” Us January

Financial statements may be prepared for any time period, but generally, to make comparisons easier, the periods are of equal length. A 12-month account- ing period is called a fiscal year; accounting periods of less than a year are called interim periods. The fiscal year of many organizations is the calendar year, Janu- ary 1 to December 31. However, retailers often end their fiscal years during a slack season, and in this case, the fiscal year corresponds to the yearly cycle of business activity.

Matching To measure net income adequately, revenues and expenses must be assigned to the accounting period in which they occur, regardless of when cash is received or paid. This is an application of the matching rule:

Revenues must be assigned to the accounting period in which the goods are sold or the services performed, and expenses must be assigned to the account- ing period in which they are used to produce revenue.

In other words, expenses should be recognized in the same accounting period as the revenues to which they are related. However, a direct cause-and-effect rela- tionship between expenses and revenues is often difficult to identify. When there is no direct means of connecting expenses and revenues, costs are allocated in a sys- tematic way among the accounting periods that benefit from the costs. For example, a building’s cost is expensed over the building’s expected useful life, and interest on investments is recorded as income even though it may not have been received.

The cash basis of accounting differs from the matching rule in that it is the practice of accounting for revenues in the period in which cash is received and for expenses in the period in which cash is paid. Some individuals and businesses use this method to account for income taxes. With this method, taxable income is calculated as the difference between cash receipts from revenues and cash pay- ments for expenses.

Although the cash basis of accounting works well for some small businesses and many individuals, it does not meet the needs of most businesses.

Ethics and the Matching Rule As shown in Figure 3-1, applying the matching rule involves making assumptions. It also involves exercising judgment. Consider the assumptions and judgment involved in estimating the useful life of a building. The estimate should be based

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Profitability Measurement: Issues and Ethics 103

on realistic assumptions, but management has latitude in making that estimate, and its judgment will affect the final net income that is reported.

The manipulation of revenues and expenses to achieve a specific outcome is called earnings management. Research has shown that companies that manage their earnings are much more likely to exceed projected earnings targets by a little than to fall short by a little. Why would management want to manage earnings to keep them from falling short? It may want to

� Meet a previously announced goal and thus meet the expectations of the market.

� Keep the company’s stock price from dropping.

� Meet a goal that will enable it to earn bonuses.

� Avoid embarrassment.

Earnings management, though not the best practice, is not illegal. However, when the estimates involved in earnings management begin moving outside a reasonable range, the financial statements become misleading. For instance, net income is misleading when revenue is overstated or expenses are understated by significant amounts. As noted earlier in the text, the preparation of financial state- ments that are intentionally misleading constitutes fraudulent financial reporting.

Most of the enforcement actions that the Securities and Exchange Com- mission has brought against companies in recent years involve misapplications of the matching rule resulting from improper accrual accounting. For example,

NET INCOME

Revenues Expensesminus

MATCHING RULE

ASSUMPTIONS

Periodicity Going Concern

FIGURE 3-1 Assumptions and the Matching Rule

FOCUS ON BUSINESS PRACTICE

Are Misstatements of Earnings Always Overstatements?

for understating its income. Microsoft, a very successful company, accomplished this by overstating its unearned revenue on the balance sheet. The company’s motive in trying to appear less successful than it actually was may have been that it was facing government charges of being a monopoly.2

Not all misstatements of earnings are overstatements. For instance, privately held companies, which do not have to be concerned about the effect of their earnings announce- ments on owners or investors, may understate income to reduce or avoid income taxes. In an unusual case involv- ing a public company, the SEC cited and fined Microsoft

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104 CHAPTER 3 Measuring Business Income

Dell Computer had to restate four years of its financial results because senior executives improperly applied accrual accounting to give the impression that the company was meeting quarterly earnings targets. After the SEC action, the com- pany conducted an internal investigation that resulted in many changes in its accounting controls.3 In the rest of this chapter, we focus on accrual accounting and its proper application.

Accrual Accounting

LO2 Define accrual account- ing, and explain how it is accomplished.

Accrual accounting encompasses all the techniques accountants use to apply the matching rule. In accrual accounting, revenues and expenses are recorded in the peri- ods in which they occur rather than in the periods in which they are received or paid.

Accrual accounting is accomplished in the following ways:

1. Recording revenues when they are earned.

2. Recording expenses when they are incurred.

3. Adjusting the accounts.

Recognizing Revenues As you may recall, the process of determining when revenue should be recorded is called revenue recognition. The Securities and Exchange Commission requires that all the following conditions be met before revenue is recognized:4

� Persuasive evidence of an arrangement exists.

� A product or service has been delivered.

� The seller’s price to the buyer is fixed or determinable.

� Collectibility is reasonably assured.

For example, suppose Miller Design Studio has created a brochure for a cus- tomer and that the transaction meets the SEC’s four criteria: Miller and the

STOP & APPLY

_____ 1. Increases in owner’s equity resulting from selling goods, rendering ser- vices, or performing other business activities

_____ 2. Manipulation of revenues and expenses to achieve a specific change in owner’s equity

_____ 3. Increase in owner’s equity that results from a company’s operations.

_____ 4. Decreases in owner’s equity result- ing from the cost of selling goods, rendering services, and other busi- ness activities.

a. Net income b. Revenues c. Expenses d. Earnings management

SOLUTION 1. b; 2. d; 3. a; 4. c

Match the assumptions or actions with the concepts below:

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Accrual Accounting 105

customer agree that the customer owes for the service, the service has been rendered, both parties understand the price, and there is a reasonable expec- tation that the customer will pay the bill. When Miller bills the customer, it records the transaction as revenue by debiting Accounts Receivable and credit- ing Design Revenue. Note that revenue can be recorded even though cash has not been collected; all that is required is a reasonable expectation that cash will be received.

Recognizing Expenses Expenses are recorded when there is an agreement to purchase goods or ser- vices, the goods have been delivered or the services rendered, a price has been established or can be determined, and the goods or services have been used to produce revenue. For example, when Miller Design Studio receives its utility bill, it recognizes the expense as having been incurred and as having helped pro- duce revenue. Miller records this transaction by debiting Utilities Expense and crediting Accounts Payable. Until the bill is paid, Accounts Payable serves as a holding account. Note that recognition of the expense does not depend on the payment of cash.

Adjusting the Accounts Accrual accounting also involves adjusting the accounts. Adjustments are neces- sary because the accounting period, by definition, ends on a particular day. The balance sheet must list all assets and liabilities as of the end of that day, and the income statement must contain all revenues and expenses applicable to the period ending on that day. Although operating a business is a continuous process, there must be a cutoff point for the periodic reports. Some transactions invariably span the cutoff point, and some accounts therefore need adjustment.

As you can see in Exhibit 3-1, some of the accounts in Miller Design Studio’s trial balance as of July 31 do not show the correct balances for preparing the financial statements. The trial balance lists prepaid rent of $3,200. At $1,600 per month, this represents rent for the months of July and August. So, on July 31, one-half of the $3,200 represents rent expense for July, and the remaining $1,600 represents an asset that will be used in August. An adjustment is needed to reflect the $1,600 balance in the Prepaid Rent account on the balance sheet and the $1,600 rent expense on the income statement.

As you will see, several other accounts in Miller Design Studio’s trial balance do not reflect their correct balances. Like the Prepaid Rent account, they need to be adjusted.

Study Note Even though certain revenues and expenses theoretically change during the period, there usually is no need to adjust them until the end of the period, when the financial statements are prepared.

FOCUS ON BUSINESS PRACTICE

Revenue Recognition: Principles Versus Rules

the other hand, has one broad IFRS for revenue recognition and leaves it to companies and their auditors to determine how to apply the broad principle. As a result, revenue recog- nition is an issue that will provide a challenge to achieving international convergence of accounting practices.

Revenue recognition highlights the differences between international and U.S. accounting standards. Although U.S. standards are referred to as generally accepted accounting principles, the FASB has issued extensive rules for revenue recognition in various situations and industries. The IASB, on

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106 CHAPTER 3 Measuring Business Income

Adjustments and Ethics Accrual accounting can be difficult to understand. The account adjustments take time to calculate and enter in the records. Also, adjusting entries do not affect cash flows in the current period because they never involve the Cash account. You might ask, “Why go to all the trouble of making them? Why worry about them?” For one thing, the SEC has identified issues related to accrual accounting and adjustments as an area of utmost importance because of the potential for abuse and misrepresentation.5

All adjustments are important because of their effect on performance measures of profitability and liquidity. Adjusting entries affect net income on the income statement, and they affect profitability comparisons from one accounting period to the next. They also affect assets and liabilities on the balance sheet and thus provide information about a company’s future cash inflows and outflows. This information is needed to assess management’s performance in achieving sufficient liquidity to meet the need for cash to pay ongoing obligations. The potential for abuse arises because considerable judgment underlies the application of adjusting entries. When this judgment is misused, performance measures can be misleading.

EXHIBIT 3-1 Trial Balance Miller Design Studio

Trial Balance July 31, 2011

Cash $22,480 Accounts Receivable 4,600 Office Supplies 5,200 Prepaid Rent 3,200 Office Equipment 16,320 Accounts Payable $ 6,280 Unearned Design Revenue 1,400 J. Miller, Capital 40,000 J. Miller, Withdrawals 2,800 Design Revenue 12,400 Wages Expense 4,800 Utilities Expense 680

$60,080 $60,080

STOP & APPLY

Four conditions must be met before revenue can be recognized. Identify which of these conditions applies to the following actions:

a. Determines that the firm has a good credit rating.

b. Agrees to a price for services before it performs them.

SOLUTION a. Collectibility is reasonably assured. b. The seller’s price to the buyer is fixed or determinable.

c. A product or service has been delivered. d. Persuasive evidence of an arrangement exists.

c. Performs services.

d. Signs a contract to perform services.

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The Adjustment Process 107

The Adjustment Process

LO3 Identify four situations that require adjusting entries, and illustrate typical adjusting entries.

When transactions span more than one accounting period, accrual accounting requires the use of adjusting entries. Figure 3-2 shows the four situations in which adjusting entries must be made. Each adjusting entry affects one balance sheet account and one income statement account. As we have already noted, adjusting entries never affect the Cash account.

The four types of adjusting entries are as follows:

Type 1. Allocating recorded costs between two or more accounting periods. Examples of these costs are prepayments of rent, insurance, and supplies and the depreciation of plant and equipment. The adjusting entry in this case involves an asset account and an expense account.

Type 2. Recognizing unrecorded, incurred expenses. Examples of these expenses are wages and interest that have been incurred but are not recorded during an accounting period. The adjusting entry involves an expense account and a liabil- ity account.

Type 3. Allocating recorded, unearned revenues between two or more account- ing periods. Examples include cash received in advance and deposits made on goods or services. The adjusting entry involves a liability account and a revenue account.

Type 4. Recognizing unrecorded, earned revenues. An example is revenue that a company has earned for providing a service but for which it has not billed or col- lected a fee by the end of the accounting period. The adjusting entry involves an asset account and a revenue account.

Adjusting entries are either deferrals or accruals.

� A deferral is the postponement of the recognition of an expense already paid (Type 1 adjustment) or of revenue received in advance (Type 3 adjustment). The cash payment or receipt is recorded before the adjusting entry is made.

� An accrual is the recognition of a revenue (Type 4 adjustment) or expense (Type 2 adjustment) that has arisen but not been recorded during the accounting period. The cash receipt or payment occurs in a future account- ing period, after the adjusting entry has been made.

Type 1 Adjustment: Allocating Recorded Costs (Deferred Expenses) Companies often make expenditures that benefit more than one period. These costs are debited to an asset account. At the end of an accounting period, the

BALANCE SHEET

Asset Liability

Expense

Revenue

1. Allocating recorded costs between two or more accounting periods.

2. Recognizing unrecorded, incurred expenses.

4. Recognizing unrecorded, earned revenues.

3. Allocating recorded, unearned revenues between two or more accounting periods.

I N C O M E S T A T E M E N T

FIGURE 3-2 The Four Types of Adjustments

Study Note Adjusting entries provide information about past or future cash flows but never involve an entry to the Cash account.

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108 CHAPTER 3 Measuring Business Income

amount of the asset that has been used is transferred from the asset account to an expense account. Two important adjustments of this type are for prepaid expenses and the depreciation of plant and equipment.

Prepaid Expenses Companies customarily pay some expenses, including those for rent, supplies, and insurance, in advance. These costs are called pre- paid expenses. By the end of an accounting period, a portion or all of prepaid services or goods will have been used or have expired. The required adjust- ing entry reduces the asset and increases the expense, as shown in Figure 3-3. The amount of the adjustment equals the cost of the goods or services used or expired.

Study Note The expired portion of a prepayment is converted to an expense; the unexpired portion remains an asset.

BALANCE SHEET

Asset

Expense

Revenue

Liability

2. Recognizing unrecorded, incurred expenses.

4. Recognizing unrecorded, earned revenues.

3. Allocating recorded, unearned revenues between two or more accounting periods.

I N C O M E S T A T E M E N T

Asset Account Expense Account

Adjusting Entry Credit

Adjusting Entry Debit

Amount equals cost of goods or services used up or expired.

1. Allocating recorded costs between two or more accounting periods.

FIGURE 3-3 Adjustment for Prepaid (Deferred) Expenses

When transactions span more than one accounting period, an adjusting entry is necessary. Depreciation of plant and equipment, such as that found in this warehouse, is a type of transaction that requires an adjusting entry. In this case, the adjusting entry involves an asset account and an expense account.

Courtesy of Timothy Babasade/ istockphoto.com.

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The Adjustment Process 109

If adjusting entries for prepaid expenses are not made at the end of an accounting period, both the balance sheet and the income statement will present incorrect information. The company’s assets will be overstated, and its expenses will be understated. Thus, owner’s equity on the balance sheet and net income on the income statement will be overstated.

To illustrate this type of adjusting entry and the others discussed below, we refer again to the transactions of Miller Design Studio.

At the beginning of July, Miller Design Studio paid two months’ rent in advance. The advance payment resulted in an asset consisting of the right to occupy the office for two months. As each day in the month passed, part of the asset’s cost expired and became an expense. By July 31, one-half of the asset’s cost had expired and had to be treated as an expense. The adjustment is as follows:

Adjustment for Prepaid Rent

July 31: Expiration of one month’s rent, $1,600.

Analysis: Expiration of prepaid rent decreases the asset account Prepaid Rent with a credit and increases the owner’s equity account Rent Expense with a debit.

Application of Double Entry:

Assets � Liabilities � Owner’s Equity PREPAID RENT RENT EXPENSE Dr. Cr. Dr. Cr. July 3 3,200 July 31 1,600 July 31 1,600

Bal. 1,600

Entry in Journal Form: Dr. Cr.

July 31 Rent Expense 1,600 Prepaid Rent 1,600

Comment: The Prepaid Rent account now has a balance of $1,600, which rep- resents one month’s rent that will be expensed during August. The logic in this analysis applies to all prepaid expenses.

Miller Design Studio purchased $5,200 of office supplies in early July. A care- ful inventory of the supplies is made at the end of the month. It records the number and cost of supplies that have not yet been consumed and are thus still assets of the company. Suppose the inventory shows that office supplies costing $3,660 are still on hand. This means that of the $5,200 of supplies originally purchased, $1,540 worth were used (became an expense) in July. The adjustment is as follows:

Adjustment for Supplies

July 31: Consumption of supplies, $1,540

Analysis: Consumption of office supplies decreases the asset account Office Supplies with a credit and increases the expense account Office Supplies Expense with a debit.

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110 CHAPTER 3 Measuring Business Income

Study Note In accounting, depreciation refers only to the allocation of an asset’s cost, not to any decline in the asset’s value.

Study Note The difficulty in estimating an asset’s useful life is further evidence that the net income figure is, at best, an estimate.

Comment: The asset account Office Supplies now reflects the correct balance of $3,660 of supplies yet to be consumed. The logic in this example applies to all kinds of supplies.

Depreciation of Plant and Equipment When a company buys a long-term asset—such as a building, truck, computer, or store fixture—it is, in effect, prepaying for the usefulness of that asset for as long as it benefits the com- pany. Because a long-term asset is a deferral of an expense, the accountant must allocate the cost of the asset over its estimated useful life. The amount allocated to any one accounting period is called depreciation, or depreciation expense. Depreciation, like other expenses, is incurred during an accounting period to produce revenue.

It is often impossible to tell exactly how long an asset will last or how much of the asset has been used in any one period. For this reason, depreciation must be estimated. Accountants have developed a number of methods for estimat- ing depreciation and for dealing with the related complex problems. (In the discussion that follows, we assume that the amount of depreciation has been established.)

To maintain historical cost in specific long-term asset accounts, separate accounts—called Accumulated Depreciation accounts—are used to accu- mulate the depreciation on each long-term asset. These accounts, which are deducted from their related asset accounts on the balance sheet, are called con- tra accounts. A contra account is a separate account that is paired with a related account—in this case, an asset account. The balance of a contra account is shown on a financial statement as a deduction from its related account. The net amount is called the carrying value, or book value, of the asset. As the months pass, the amount of the accumulated depreciation grows, and the carrying value of the asset declines.

Adjustment for Plant and Equipment

July 31: Depreciation of office equipment, $300

Analysis: Depreciation decreases the asset account Office Equipment by increas- ing the contra account Accumulated Depreciation–Office Equipment with a credit and increasing the owner’s equity account Depreciation Expense–Office Equip- ment with a debit.

Application of Double Entry:

Assets � Liabilities � Owner’s Equity OFFICE SUPPLIES OFFICE SUPPLIES EXPENSE

Dr. Cr. Dr. Cr. July 5 5,200 July 31 1,540 July 31 1,540 Bal. 3,660

Entry in Journal Form: Dr. Cr.

July 31 Office Supplies Expense 1,540 Office Supplies 1,540

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The Adjustment Process 111

Application to Netflix, Inc. Netflix has prepaid expenses and property and equipment similar to those in the examples we have presented. Among Netflix’s prepaid expenses are payments made in advance to movie companies for rights to DVDs. By paying in advance, Netflix is able to negotiate lower prices. These fixed payments are debited to Prepaid Expense. When the movies produce reve- nue, the prepaid amounts are transferred to expense through adjusting entries.6

Type 2 Adjustment: Recognizing Unrecorded, Incurred Expenses (Accrued Expenses) Usually, at the end of an accounting period, some expenses incurred during the period have not been recorded in the accounts. These expenses require adjust- ing entries. One such expense is interest on borrowed money. Each day, interest accumulates on the debt. As shown in Figure 3-4, at the end of the account- ing period, an adjusting entry is made to record the accumulated interest, which is an expense of the period, and the corresponding liability to pay the interest. Other common unrecorded expenses are wages and utilities. As the expense and the corresponding liability accumulate, they are said to accrue—hence, the term accrued expenses.

To illustrate how adjustments are made for unrecorded, incurred wages, sup- pose Miller Design Studio has two pay periods a month rather than one. In July, its pay periods end on the 12th and the 26th, as indicated in the calendar on the next page.

Study Note Remember that in accrual accounting, an expense must be recorded in the period in which it is incurred regardless of when payment is made.

Application of Double Entry:

Assets � Liabilities � Owner’s Equity OFFICE EQUIPMENT DEPRECIATION EXPENSE–

Dr. Cr. OFFICE EQUIPMENT Dr. Cr.July 6 16,320

July 31 300

ACCUMULATED DEPRECIATION– OFFICE EQUIPMENT

Dr. Cr. July 31 300

Entry in Journal Form: Dr. Cr.

July 31 Depreciation Expense–Office Equipment 300

Accumulated Depreciation– Office Equipment 300

Comment: The carrying value of Office Equipment is $16,020 ($16,320 � $300) and is presented on the balance sheet as follows:

PROPERTY, PLANT, AND EQUIPMENT Office equipment $16,320 Less accumulated depreciation 300 $16,020

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112 CHAPTER 3 Measuring Business Income

By the end of business on July 31, Miller’s assistant will have worked three days (Monday, Tuesday, and Wednesday) beyond the last pay period. The employee has earned the wages for those days but will not be paid until the first payday in August. The wages for these three days are rightfully an expense for July, and the liabilities should reflect that the company owes the assistant for those days. Because the assistant’s wage rate is $2,400 every two weeks, or $240 per day ($2,400�10 working days), the expense is $720 ($240 � 3 days).

Adjustment for Unrecorded Wages

July 31: Accrual of unrecorded wages, $720

Analysis: Accrual of wages increases the owner’s equity account Wages Expense with a debit and increases the liability account Wages Payable with a credit.

BALANCE SHEET

3. Allocating recorded, unearned revenues between two or more accounting periods.

4. Recognizing unrecorded, earned revenues.

1. Allocating recorded costs between two or more accounting periods.

Expense

Revenue

Asset

Liability

Adjusting Entry Credit

Adjusting Entry Debit

2. Recognizing unrecorded, incurred expenses.

Liability Account Expense Account

Amount equals cost of expense incurred.

I N C O M E S T A T E M E N T

Application of Double Entry:

Assets � Liabilities � Owner’s Equity WAGES PAYABLE WAGES EXPENSE

Dr. Cr. Dr. Cr. July 31 720 July 26 4,800

31 720 Bal. 5,520

Entry in Journal Form: Dr. Cr.

July 31 Wages Expense 720 Wages Payable 720

FIGURE 3-4 Adjustment for Unrecorded (Accrued) Expenses

JULY

SUN M T W TH F SAT 1 2 3 4 5 6

7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31

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The Adjustment Process 113

Comment: Note that the increase in Wages Expense will decrease owner’s equity and that total wages for the month are $5,520, of which $720 will be paid next month.

Application to Netflix, Inc. In 2008, Netflix had accrued expenses of $31,394,000.7 If the expenses had not been accrued, Netflix’s liabilities would be significantly understated, as would the corresponding expenses on Netflix’s income statement. The end result would be an overstatement of the company’s earnings.

Type 3 Adjustment: Allocating Recorded, Unearned Revenues (Deferred Revenues) Just as expenses can be paid before they are used, revenues can be received before they are earned. When a company receives revenues in advance, it has an obli- gation to deliver goods or perform services. Unearned revenues are therefore shown in a liability account.

For example, publishing companies usually receive cash in advance for maga- zine subscriptions. These receipts are recorded in a liability account, Unearned Subscriptions. If the company fails to deliver the magazines, subscribers are enti- tled to their money back. As the company delivers each issue of the magazine, it earns a part of the advance receipts. This earned portion must be transferred from the Unearned Subscriptions account to the Subscription Revenue account, as shown in Figure 3-5.

During July, Miller Design Studio received $1,400 from another firm as advance payment for a series of brochures. By the end of the month, it had com- pleted $800 of work on the brochures, and the other firm had accepted the work.

Adjustment for Unearned Revenue

July 31: Performance of services for which cash was received in advance, $800

Analysis: Performing the services for which cash was received in advance increases the owner’s equity account Design Revenue with a credit and decreases the liability account Unearned Design Revenue with a debit.

Study Note Unearned revenue is a liability because there is an obligation to deliver goods or perform a service, or to return the payment. Once the goods have been delivered or the service performed, the liability is transferred to revenue.

BALANCE SHEET

Asset Liability

Expense

Revenue

1. Allocating recorded costs between two or more accounting periods.

2. Recognizing unrecorded, incurred expenses.

4. Recognizing unrecorded, earned revenues.

I N C O M E S T A T E M E N T

3. Allocating recorded, unearned revenues between two or more accounting periods.

Liability Account

Adjusting Entry Debit

Amount equals price of services performed

or goods delivered.

Adjusting Entry Credit

Revenue Account

FIGURE 3-5 Adjustment for Unearned (Deferred) Revenues

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114 CHAPTER 3 Measuring Business Income

Application to Netflix, Inc. Netflix has a current liability account called Deferred (Unearned) Revenue. Deferred revenue consists of subscriptions (monthly payments) billed in advance to customers for which revenues have not yet been earned. Subscription revenues are recognized by prorating them over each subscriber’s monthly subscription period. As time passes and customers use the service, the revenue is transferred from Netflix’s Deferred Revenue account to its Subscription Revenue account.

Type 4 Adjustment: Recognizing Unrecorded, Earned Revenues (Accrued Revenues) Accrued revenues are revenues that a company has earned by performing a service or delivering goods but for which no entry has been made in the accounting records. Any revenues earned but not recorded during an account- ing period require an adjusting entry that debits an asset account and credits a revenue account, as shown in Figure 3-6. For example, the interest on a note

Application of Double Entry:

Assets � Liabilities � Owner’s Equity UNEARNED DESIGN REVENUE DESIGN REVENUE

Dr. Cr. Dr. Cr. July 31 800 July 19 1,400 July 10 2,800 Bal. 600 15 9,600 31 800 Bal. 13,200

Entry in Journal Form: Dr. Cr.

July 31 Unearned Design Revenue 800 Design Revenue 800

Comment: Unearned Design Revenue now reflects the amount of work still to be performed, $600.

Asset Liability

1. Allocating recorded costs between two or more accounting periods.

2. Recognizing unrecorded, incurred expenses.

3. Allocating recorded, unearned revenues between two or more accounting periods.

BALANCE SHEET

Expense

Revenue

I N C O M E S T A T E M E N T

4. Recognizing unrecorded, earned revenues.

Asset Account Revenue Account

Adjusting Entry Debit

Adjusting Entry Credit

Amount equals price of services performed.

FIGURE 3-6 Adjustment for Unrecorded (Accrued) Revenues

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The Adjustment Process 115

receivable is earned day by day but may not be received until another account- ing period. The Interest Receivable account should be debited and the Interest Income account should be credited for the interest accrued at the end of the current period.

When a company earns revenue by performing a service—such as designing a series of brochures or developing marketing plans—but will not receive the revenue for the service until a future accounting period, it must make an adjust- ing entry. This type of adjusting entry involves an asset account and a revenue account.

During July, Miller Design Studio agreed to create two advertisements for Maggio’s Pizza Company. It also agreed that the first advertisement would be finished by July 31. By the end of the month, Miller had earned $400 for com- pleting the first advertisement. The client will not be billed until the entire proj- ect has been completed.

Adjustment for Design Revenue

July 31: Accrual of unrecorded revenue, $400

Analysis: Accrual of unrecorded revenue increases the owner’s equity account Design Revenue with a credit and increases the asset account Accounts Receivable with a debit.

Application of Double Entry:

Assets � Liabilities � Owner’s Equity ACCOUNTS RECEIVABLE DESIGN REVENUE

Dr. Cr. Dr. Cr. July 15 9,600 July 22 5,000 July 10 2,800 31 400 15 9,600 Bal. 5,000 31 800 31 400 Bal. 13,600

Entry in Journal Form: Dr. Cr. July 31 Accounts Receivable 400 Design Revenue 400

Comment: Design Revenue now reflects the total revenue earned during July, $13,600. Some companies prefer to debit an account called Unbilled Accounts Receivable. Other companies simply flag the transactions in Accounts Receivable as “unbilled.” On the balance sheet, they are usually combined with accounts receivable.

Application to Netflix, Inc. Since Netflix’s subscribers pay their subscrip- tions in advance by credit card, Netflix does not need to bill customers for ser- vices provided but not paid. The company is in the enviable position of having no accounts receivable and thus a high degree of liquidity.

A Note About Journal Entries Thus far, we have presented a full analysis of each journal entry. The analyses showed you the thought process behind each entry. By now, you should be fully

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116 CHAPTER 3 Measuring Business Income

Using the Adjusted Trial Balance to Prepare Financial Statements

LO4 Prepare financial statements from an adjusted trial balance.

STOP & APPLY

Type 1. Allocating recorded costs between two or more accounting periods

Type 2. Recognizing unrecorded, incurred expenses

Type 3. Allocating recorded, unearned revenues between two or more accounting periods

Type 4. Recognizing unrecorded, earned revenues

SOLUTION a. Type 4; b. Type 2; c. Type 1; d. Type 1

For each of the following items, identify the type of adjusting entry required: ___ a. Revenues earned but not yet collected or billed to customers ___ b. Interest incurred but not yet recorded ___ c. Unused supplies ___ d. Costs of plant and equipment

After adjusting entries have been recorded and posted, an adjusted trial balance is prepared by listing all accounts and their balances. If the adjusting entries have been posted to the accounts correctly, the adjusted trial balance will have equal debit and credit totals. The adjusted trial balance for Miller Design Studio is shown in Exhibit 3-2.

Some accounts in Exhibit 3-2, such as Cash and Accounts Payable, have the same balances as in the trial balance in Exhibit 3-1 because no adjusting entries affected them. The balances of other accounts, such as Office Supplies and Pre- paid Rent, differ from those in the trial balance because adjusting entries did affect them. The adjusted trial balance also has some new accounts, such as depreciation accounts and Wages Payable, that are not in the trial balance.

The adjusted trial balance facilitates the preparation of the financial state- ments. As shown in Exhibit 3-2, the revenue and expense accounts are used to prepare the income statement.

aware of the effects of transactions on the accounting equation and the rules of debit and credit. For this reason, in the rest of the book, we present journal entries without full analysis.

The four types of adjusting entries are as follows:

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Using the Adjusted Trial Balance to Prepare Financial Statements 117

EXHIBIT 3-2 Relationship of the Adjusted Trial Balance to the Income Statement

Then, as shown in Exhibit 3-3, the statement of owner’s equity and the bal- ance sheet are prepared. Notice that the net income from the income statement is combined with the Withdrawals account on the statement of owner’s equity to give the net change in the J. Miller, Capital account.

The resulting balance of J. Miller, Capital at July 31 is used in preparing the balance sheet, as are the asset and liability account balances in the adjusted trial balance.

Study Note The adjusted trial balance is a second check that the ledger is still in balance. Because it reflects updated information from the adjusting entries, it is used in preparing the formal financial statements. It does not mean there are no accounting errors.

Miller Design Studio Adjusted Trial Balance

July 31, 2011

Cash $22,480 Accounts Receivable 5,000 Office Supplies 3,660 Prepaid Rent 1,600 Office Equipment 16,320 Accumulated Depreciation– Office Equipment $ 300 Accounts Payable 6,280 Unearned Design Revenue 600 Wages Payable 720 J. Miller, Capital 40,000 J. Miller, Withdrawals 2,800 Design Revenue 13,600 Wages Expense 5,520 Utilities Expense 680 Rent Expense 1,600 Office Supplies Expense 1,540 Depreciation Expense– Office Equipment 300

$61,500 $61,500

Miller Design Studio Income Statement

For the Month Ended July 31, 2011

Revenues Design revenue $13,600 Expenses Wages expense $5,520 Utilities expense 680 Rent expense 1,600 Office supplies expense 1,540 Depreciation expense– office equipment 300

Total expenses 9,640

Net income $ 3,960

Study Note The net income figure from the income statement is needed to prepare the statement of owner’s equity, and the bottom-line figure of that statement is needed to prepare the balance sheet. This dictates the order in which the statements are prepared.

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118 CHAPTER 3 Measuring Business Income

EXHIBIT 3-3 Relationship of the Adjusted Trial Balance to the Balance Sheet and Statement of Owner’s Equity

Miller Design Studio Adjusted Trial Balance

July 31, 2011

$61,500 $61,500

Miller Design Studio Balance Sheet July 31, 2011

Assets

Cash $22,480 Accounts receivable 5,000 Office supplies 3,660 Prepaid rent 1,600 Office equipment $16,320 Less accumulated depreciation 300 16,020

Total assets $48,760

Liabilities

Accounts payable $ 6,280 Unearned design revenue 600 Wages payable 720

Total liabilities $ 7,600

Owner’s Equity J. Miller, Capital 41,160

Total liabilities and owner’s equity $48,760

Miller Design Studio Statement of Owner’s Equity

For the Month Ended July 31, 2011

J. Miller, Capital, July 1, 2011 $ 0 Investment by J. Miller 40,000

Net income 3,960

Subtotal $43,960

Less withdrawals 2,800

J. Miller, Capital, July 31, 2011 $41,160

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Cash Flows from Accrual-Based Information 119

Cash Flows from Accrual- Based Information

LO5 Use accrual-based information to analyze cash flows.

Management has the short-range goal of ensuring that its company has sufficient cash to pay ongoing obligations—in other words, management must ensure the company’s liquidity. To plan payments to creditors and assess the need for short- term borrowing, managers must know how to use accrual-based information to analyze cash flows.

Almost every revenue or expense account on the income statement has one or more related accounts on the balance sheet. For instance, Office Supplies Expense is related to Office Supplies, Wages Expense is related to Wages Payable, and Design Revenue is related to Unearned Design Revenue. As we have shown, these accounts are related by making adjusting entries, the purpose of which is to apply the matching rule to the measurement of net income.

The cash inflows that a company’s operations generate and the cash outflows that they require can also be determined by analyzing these relationships. For exam- ple, suppose that after receiving the financial statements in Exhibits 3-2 and 3-3, management wants to know how much cash was expended for office supplies. On the income statement, Office Supplies Expense is $1,540, and on the balance sheet, Office Supplies is $3,660. Because July was the company’s first month of operation, there was no prior balance of office supplies, so the amount of cash expended for office supplies during the month was $5,200 ($1,540 � $3,660 � $5,200).

Thus, the cash flow used in purchasing office supplies—$5,200—was much greater than the amount expensed in determining income—$1,540. In planning for August, management can anticipate that the cash needed may be less than the amount expensed because, given the large inventory of office supplies, the company will probably not have to buy office supplies in the coming month. Understanding these cash flow effects enables management to better predict the business’s need for cash in August.

The general rule for determining the cash flow received from any revenue or paid for any expense (except depreciation, which is a special case not covered

STOP & APPLY

The adjusted trial balance for Carroll Company on December 31, 2010, contains the follow- ing accounts and balances: D. Carroll, Capital, $300; D. Carroll, Withdrawals, $100; Service Revenue, $1,000; Rent Expense, $300; Wages Expense, $400; and Telephone Expense, $100. Compute net income and prepare a statement of owner’s equity in proper form for the month of December.

SOLUTION Net income � $1,000 � $300 � $400 � $100 � $1,000 � $800 � $200

Carroll Company Statement of Owner’s Equity

For the Month Ended December 31, 2010 D. Carroll, Capital, Dec. 1, 2010 $ 300 Net income 200 Subtotal $ 500 Less withdrawals 100 D. Carroll, Capital, Dec. 31, 2010 $ 400

Study Note Income as determined by accrual accounting is important to a company’s profitability. Cash flows are related to a company’s liquidity. Both are important to a company’s success.

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120 CHAPTER 3 Measuring Business Income

here) is to determine the potential cash payments or cash receipts and deduct the amount not paid or not received. As shown below, the application of the general rule varies with the type of asset or liability account:

Potential Payment or Receipt Not Paid or Type of Account Received Result

Prepaid Expense Ending Balance � Expense � Cash Payments for for the Period � Beginning Expenses Balance

Unearned Revenue Ending Balance � Revenue � Cash Receipts from for the Period � Beginning Revenues Balance

Accrued Expense Beginning Balance � � Cash Payments for Expense for the Period � Expenses Ending Balance

Accrued Revenue Beginning Balance � � Cash Receipts from Revenue for the Period � Revenues Ending Balance

For instance, suppose that on May 31, a company had a balance of $480 in Prepaid Insurance and that on June 30, the balance was $670. If the insurance expense during June was $120, the amount of cash expended on insurance dur- ing June can be computed as follows:

Prepaid Insurance at June 30 $670

Insurance Expense during June 120

Potential cash payments for insurance $790

Less Prepaid Insurance at May 31 480

Cash payments for insurance during June $310

The beginning balance is deducted because it was paid in a prior accounting period. Note that the cash payments equal the expense plus the increase in the balance of the Prepaid Insurance account [$120 � ($670 � $480) � $310]. In this case, the cash paid was almost three times the amount of insurance expense. In future months, cash payments are likely to be less than the expense.

STOP & APPLY

Supplies had a balance of $400 at the end of May and $360 at the end of June. Supplies Expense was $550 for the month of June. How much cash was received for services provided during June?

SOLUTION Supplies at June 30 $360 Supplies Expense during June 550 Potential cash payments for supplies $910 Less Supplies at May 31 400 Cash payments for supplies during June $510

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Reliable Answering Service: Review Problem 121

RELIABLE ANSWERING SERVICE: REVIEW PROBLEM In the Decision Point at the beginning of the chapter, we noted that Reliable Answering Service has many transactions that span accounting periods. We asked these questions:

• What assumptions must Reliable Answering Service make to account for transactions that span accounting periods?

• How does Reliable assign its revenues and expenses to the proper accounting period so that net income is properly measured?

• Why are the adjustments that these transactions require important to Reliable’s financial performance?

Two of the assumptions Reliable must make are that it will continue as a going con- cern for an indefinite time (the continuity assumption) and that it can make useful esti- mates of its income in terms of accounting periods (the periodicity assumption). These assumptions enable the company to apply the matching rule—that is, revenues are assigned to the accounting period in which goods are sold or services are performed, and expenses are assigned to the accounting period in which they are used to produce rev- enue. These adjustments are important in order to measure net income adequately.

In addition to Reliable’s trial balance, which appears at the beginning of the chapter, the following information is also available for the company on December 31, 2011:

• Why are the adjustments that these transactions require important to Reliable’s financial performance?

a. Insurance that expired during December amounted to $40.

b. Office supplies on hand on December 31 totaled $75.

c. Depreciation for December totaled $100.

d. Accrued wages on December 31 totaled $120.

e. Revenues earned for services performed in December but not billed by the end of the month totaled $300.

f. Revenues received in December in advance of services yet to be performed totaled $160.

Required 1. Prepare T accounts for the accounts in the trial balance, and enter the balances.

2. Determine the required adjusting entries, and record them directly in the T accounts. Open new T accounts as needed.

3. Prepare an adjusted trial balance.

4. Prepare an income statement, a statement of owner’s equity, and a balance sheet for the month ended December 31, 2011.

5. User insight: Which accounts on Reliable’s income statement are potentially affected by adjusting entries? Which account on Reliable’s balance sheet is never affected by an adjusting entry?

�

Posting to T Accounts, Determining Adjusting

Entries, and Using an Adjusted Trial Balance

to Prepare Financial Statements

LO3 LO4

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122 CHAPTER 3 Measuring Business Income

1. T accounts set up and amounts from trial balance entered 2. Adjusting entries recorded

Answers to Review Problem

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Reliable Answering Service: Review Problem 123

3. Adjusted trial balance prepared

4. Financial statements prepared

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124 CHAPTER 3 Measuring Business Income

5. All accounts on the income statement are potentially affected by adjusting entries. Cash on the balance sheet is never affected by an adjusting entry.

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Stop & Review 125

STOP & REVIEW

Net income is the net increase in owner’s equity that results from a company’s operations. Net income equals revenues minus expenses; when expenses exceed revenues, a net loss results. Revenues equal the price of goods sold or services rendered during a specific period. Expenses are the costs of goods and services used in the process of producing revenues.

The continuity assumption recognizes that even though businesses face an uncertain future, without evidence to the contrary, accountants must assume that a business will continue to operate indefinitely. The periodicity assumption recognizes that although the lifetime of a business is uncertain, it is nonetheless useful to estimate the business’s net income in terms of account- ing periods. The matching rule holds that revenues must be assigned to the accounting period in which the goods are sold or the services performed, and expenses must be assigned to the accounting period in which they are used to produce revenue.

Because applying the matching rule involves making assumptions and exercis- ing judgment, it can lead to earnings management, which is the manipulation of revenues and expenses to achieve a specific outcome. When the estimates involved in earnings management move outside a reasonable range, financial statements become misleading. Financial statements that are intentionally misleading consti- tute fraudulent financial reporting.

LO1 Defi ne net income, and explain the assump-

tions underlying income measurement and their

ethical application.

LO2 Defi ne accrual account- ing, and explain how it is

accomplished.

Accrual accounting consists of all the techniques accountants use to apply the matching rule. It is accomplished by recognizing revenues when they are earned, by recognizing expenses when they are incurred, and by adjusting the accounts.

LO3 Identify four situations that require adjusting entries, and illustrate

typical adjusting entries.

Adjusting entries are required when (1) recorded costs must be allocated between two or more accounting periods, (2) unrecorded expenses exist, (3) recorded, unearned revenues must be allocated between two or more accounting periods, and (4) unrecorded, earned revenues exist. The preparation of adjusting entries is summarized as follows:

Type of Account

Type of Adjusting Entry Debited Credited Examples of Balance Sheet Accounts

1. Allocating recorded costs (previously paid, expired)

Expense Asset (or contra-asset)

Prepaid rent Prepaid insurance Office supplies Accumulated depreciation–office equipment

2. Accrued expenses (incurred, not paid)

Expense Liability Interest payable Wages payable

3. Allocating recorded, unearned revenues (previously received, earned)

Liability Revenue Unearned design revenue

4. Accrued revenues (earned, not received)

Asset Revenue Accounts receivable Interest receivable

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126 CHAPTER 3 Measuring Business Income

LO4 Prepare fi nancial state- ments from an adjusted

trial balance.

An adjusted trial balance is prepared after adjusting entries have been posted to the accounts. Its purpose is to test whether the adjusting entries have been posted cor- rectly before the financial statements are prepared. The balances in the revenue and expense accounts in the adjusted trial balance are used to prepare the income state- ment. The balances in the asset and liability accounts in the adjusted trial balance and in the statement of owner’s equity are used to prepare the balance sheet.

LO5 Use accrual-based infor- mation to analyze cash

fl ows.

To ensure a company’s liquidity, managers must know how to use accrual-based information to analyze cash flows. The general rule for determining the cash flow received from any revenue or paid for any expense (except depreciation) is to determine the potential cash receipts or cash payments and deduct the amount not received or not paid.

The following concepts and terms were introduced in this chapter: Accrual 107 (LO3) Accrual accounting 104 (LO2) Accrued expenses 111 (LO3) Accrued revenues 114 (LO3) Accumulated Depreciation

accounts 110 (LO3) Adjusted trial balance 116 (LO4) Adjusting entries 107 (LO3) Carrying value 110 (LO3)

Cash basis of accounting 102 (LO1) Continuity 101 (LO1) Contra account 110 (LO3) Deferral 107 (LO3) Depreciation 110 (LO3) Earnings management 103 (LO1) Expenses 101 (LO1) Fiscal year 102 (LO1) Going concern 101 (LO1) Interim periods 102 (LO1)

Matching rule 102 (LO1) Net income 100 (LO1) Net loss 100 (LO1) Periodicity 101 (LO1) Prepaid expenses 108 (LO3) Profit 100 (LO1) Revenue recognition 104 (LO2) Revenues 100 (LO1) Unearned revenues 113 (LO3)

REVIEW of Concepts and Terminology

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Chapter Assignments 127

CHAPTER ASSIGNMENTS BUILDING Your Basic Knowledge and Skills

Short Exercises

Accrual Accounting Concepts SE 1. Match the concepts of accrual accounting on the right with the assumptions or actions on the left:

___ 1. Assumes expenses should be assigned to the accounting period in which they are used to produce revenues

___ 2. Assumes a business will last indefinitely ___ 3. Assumes revenues are earned at a point

in time ___ 4. Assumes net income that is measured

for a short period of time, such as one quarter, is a useful measure

Adjustment for Prepaid Insurance SE 2. The Prepaid Insurance account began the year with a balance of $920. Dur- ing the year, insurance in the amount of $2,080 was purchased. At the end of the year (December 31), the amount of insurance still unexpired was $1,400. Prepare the year-end entry in journal form to record the adjustment for insurance expense for the year.

Adjustment for Supplies SE 3. The Supplies account began the year with a balance of $760. During the year, sup- plies in the amount of $1,960 were purchased. At the end of the year (December 31), the inventory of supplies on hand was $880. Prepare the year-end entry in journal form to record the adjustment for supplies expense for the year.

Adjustment for Depreciation SE 4. The depreciation expense on office equipment for the month of March is $100. This is the third month that the office equipment, which cost $1,900, has been owned. Prepare the adjusting entry in journal form to record depreciation for March and show the balance sheet presentation for office equipment and related accounts after the March 31 adjustment.

Adjustment for Accrued Wages SE 5. Wages are paid each Saturday for a six-day workweek. Wages are currently running $1,380 per week. Prepare the adjusting entry required on June 30, assuming July 1 falls on a Tuesday.

Adjustment for Unearned Revenue SE 6. During the month of August, deposits in the amount of $2,200 were received for services to be performed. By the end of the month, services in the amount of $1,520 had been performed. Prepare the necessary adjustment for Service Revenue at the end of the month.

LO1 LO2

a. Periodicity b. Continuity c. Matching rule d. Revenue recognition

LO3

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128 CHAPTER 3 Measuring Business Income

Preparation of an Income Statement and Statement of Owner’s Equity from an Adjusted Trial Balance SE 7. The adjusted trial balance for Shimura Company on December 31, 2010, contains the following accounts and balances: J. Shimura, Capital, $4,300; J. Shimura, Withdrawals, $175; Service Revenue, $1,300; Rent Expense, $200; Wages Expense, $450; Utilities Expense, $100; and Telephone Expense, $25. Prepare an income statement and statement of owner’s equity in proper form for the month of December.

Determination of Cash Flows SE 8. Unearned Revenue had a balance of $650 at the end of November and $450 at the end of December. Service Revenue was $2,550 for the month of December. How much cash was received for services provided during December?

Exercises Discussion Questions E 1. Develop a brief answer to each of the following questions. 1. When a company has net income, what happens to its assets and/or to its

liabilities? 2. Is accrual accounting more closely related to a company’s goal of profitability

or liquidity? 3. Will the carrying value of a long-term asset normally equal its market value?

Discussion Questions E 2. Develop a brief answer to each of the following questions. 1. If, at the end of the accounting period, you were looking at the T account for

a prepaid expense like supplies, would you look for the amounts expended in cash on the debit or credit side? On which side would you find the amount expensed during the period?

2. Would you expect net income to be a good measure of a company’s liquid- ity? Why or why not?

Applications of Accounting Concepts Related to Accrual Accounting E 3. The accountant for Ronaldo Company makes the assumptions or per- forms the activities listed below. Tell which of the following concepts of accrual accounting most directly relates to each assumption or action: (a) periodicity, (b) continuity, (c) matching rule, (d) revenue recognition, (e) deferral, and (f) accrual. 1. In estimating the life of a building, assumes that the business will last

indefinitely 2. Records a sale when the customer is billed 3. Postpones the recognition of a one-year insurance policy as an expense by

initially recording the expenditure as an asset 4. Recognizes the usefulness of financial statements prepared on a monthly basis

even though they are based on estimates 5. Recognizes, by making an adjusting entry, wages expense that has been

incurred but not yet recorded 6. Prepares an income statement that shows the revenues earned and the

expenses incurred during the accounting period

LO4

LO5

LO1 LO2 LO3

LO4

LO1 LO2 LO3

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Chapter Assignments 129

Application of Conditions for Revenue Recognition E 4. Four conditions must be met before revenue should be recognized. In each of the following cases, tell which condition has not been met. a. Company A accepts a contract to perform services in the future for $2,000. b. Company B ships products worth $3,000 to another company without an

order from the other company but tells the company it can return the prod- ucts if it does not sell them.

c. Company C performs $10,000 of services for a firm with financial problems. d. Company D agrees to work out a price later for services that it performs for

another company.

Adjusting Entry for Unearned Revenue E 5. Fargo Voice of Fargo, North Dakota, publishes a monthly magazine featur- ing local restaurant reviews and upcoming social, cultural, and sporting events. Subscribers pay for subscriptions either one year or two years in advance. Cash received from subscribers is credited to an account called Magazine Subscriptions Received in Advance. On December 31, 2009, the end of the company’s fiscal year, the balance of this account is $840,000. Expiration of subscriptions revenue is as follows:

During 2009 $175,000 During 2010 415,000 During 2011 250,000

Prepare the adjusting entry in journal form for December 31, 2009.

Adjusting Entries for Prepaid Insurance E 6. An examination of the Prepaid Insurance account shows a balance of $16,845 at the end of an accounting period, before adjustment. Prepare entries in journal form to record the insurance expense for the period under the following indepen- dent assumptions: 1. An examination of the insurance policies shows unexpired insurance that cost

$8,270 at the end of the period. 2. An examination of the insurance policies shows insurance that cost $2,150

has expired during the period.

Adjusting Entries for Supplies: Missing Data E 7. Each of the following columns represents a Supplies account:

a b c d Supplies on hand at July 1 $264 $346 $196 $ ? Supplies purchased during the month 113 ? 174 1,928 Supplies consumed during the month 194 972 ? 1,741 Supplies on hand at July 31 ? 436 85 1,118

1. Determine the amounts indicated by the question marks. 2. Make the adjusting entry for column a, assuming supplies purchased are deb-

ited to an asset account.

Adjusting Entry for Accrued Salaries E 8. Hugo Company has a five-day workweek and pays salaries of $35,000 each Friday. 1. Prepare the adjusting entry required on May 31, assuming that June 1 falls

on a Wednesday. 2. Prepare the entry to pay the salaries on June 3, including the amount of sala-

ries payable from requirement 1.

LO2

LO3

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130 CHAPTER 3 Measuring Business Income

Revenue and Expense Recognition E 9. Optima Company produces computer software that Tech Company sells. Optima receives a royalty of 15 percent of sales. Tech Company pays royalties to Optima Company semiannually—on May 1 for sales made in July through December of the previous year and on November 1 for sales made in January through June of the current year. Royalty expense for Tech Company and royalty income for Optima Company in the amount of $6,000 were accrued on Decem- ber 31, 2008. Cash in the amounts of $6,000 and $10,000 was paid and received on May 1 and November 1, 2009, respectively. Software sales during the July to December 2009 period totaled $150,000. 1. Calculate the amount of royalty expense for Tech Company and royalty

income for Optima during 2009. 2. Record the adjusting entry that each company made on December 31, 2009.

Preparation of Financial Statements E 10. Prepare the monthly income statement, monthly statement of owner’s equity, and the balance sheet at August 31, 2011, for Alvin Cleaning Company from the data provided in the adjusted trial balance below. The owner made no investments during the period.

LO3

LO4

Alvin Cleaning Company Adjusted Trial Balance

August 31, 2011

Cash $ 4,750 Accounts Receivable 2,592 Prepaid Insurance 380 Prepaid Rent 200 Cleaning Supplies 152 Cleaning Equipment 3,875 Accumulated Depreciation–Cleaning Equipment $ 320 Truck 7,200 Accumulated Depreciation–Truck 720 Accounts Payable 420 Wages Payable 295 Unearned Janitorial Revenue 1,690 A. Wish, Capital 15,034 A. Wish, Withdrawals 2,000 Janitorial Revenue 14,620 Wages Expense 5,680 Rent Expense 1,350 Gas, Oil, and Other Truck Expenses 580 Insurance Expense 380 Supplies Expense 2,920 Depreciation Expense–Cleaning Equipment 320 Depreciation Expense–Truck 720

$33,099 $33,099

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Chapter Assignments 131

Adjusting Entries E 11. Prepare year-end adjusting entries for each of the following: 1. Office Supplies has a balance of $336 on January 1. Purchases debited to

Office Supplies during the year amount to $1,660. A year-end inventory reveals supplies of $1,140 on hand.

2. Depreciation of office equipment is estimated to be $2,130 for the year. 3. Property taxes for six months, estimated at $1,800, have accrued but have

not been recorded. 4. Unrecorded interest income on U.S. government bonds is $850. 5. Unearned Revenue has a balance of $1,800. Services for $750 received in

advance have now been performed. 6. Services totaling $800 have been performed; the customer has not yet been

billed.

Accounting for Revenue Received in Advance E 12. Robert Shapiro, a lawyer, received $84,000 on October 1 to represent a cli- ent in real estate negotiations over the next 12 months. 1. Record the entries required in Shapiro’s records on October 1 and at the end

of the fiscal year, December 31. 2. How would this transaction be reflected on the income statement and bal-

ance sheet on December 31?

Determination of Cash Flows E 13. After adjusting entries had been made, the balance sheets of Ramiro’s Com- pany showed the following asset and liability amounts at the end of 2009 and 2010:

2010 2009 Prepaid insurance $2,400 $2,900 Wages payable 1,200 2,200 Unearned fees 4,200 1,900

The following amounts were taken from the 2010 income statement:

Insurance expense $ 3,800 Wages expense 19,500 Fees earned 8,900

Calculate the amount of cash paid for insurance and wages and the amount of cash received for fees during 2010.

Relationship of Expenses to Cash Paid E 14. The income statement for Sahan Company included the following expenses for 2011:

Rent expense $ 75,000 Interest expense 11,700 Salaries expense 121,000

LO3

LO5

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132 CHAPTER 3 Measuring Business Income

Listed below are the related balance sheet account balances at year end for last year and this year.

Last Year This Year Prepaid rent — $ 1,350 Interest payable $1,500 — Salaries payable 7,500 114,000

1. Compute the cash paid for rent during the year. 2. Compute the cash paid for interest during the year. 3. Compute the cash paid for salaries during the year.

Problems Determining Adjustments P 1. At the end of the first three months of operation, the trial balance of City Answering Service appears as shown below. Tim Bass, the owner of City Answer- ing Service, has hired an accountant to prepare financial statements to determine how well the company is doing after three months. Upon examining the account- ing records, the accountant finds the following items of interest: a. An inventory of office supplies reveals supplies on hand of $150. b. The Prepaid Rent account includes the rent for the first three months plus a

deposit for April’s rent. c. Depreciation on the equipment for the first three months is $416. d. The balance of the Unearned Answering Service Revenue account represents

a 12-month service contract paid in advance on February 1. e. On March 31, accrued wages total $105.

LO3

Required All adjustments affect one balance sheet account and one income statement account. For each of the above situations, show the accounts affected, the amount

City Answering Service Trial Balance

March 31, 2010

Cash $ 3,582 Accounts Receivable 4,236 Office Supplies 933 Prepaid Rent 800 Equipment 4,700 Accounts Payable $ 2,673 Unearned Answering Service Revenue 888 T. Bass, Capital 5,933 T. Bass, Withdrawals 2,100 Answering Service Revenue 9,102 Wages Expense 1,900 Office Cleaning Expense 345

$18,596 $18,596

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Chapter Assignments 133

of the adjustment (using a � or – to indicate an increase or decrease), and the balance of the account after the adjustment in the following format:

Balance Amount of Income Amount of Sheet Adjustment Balance After Statement Adjustment Balance After

Account (� or �) Adjustment Account (� or �) Adjustment

Preparing Adjusting Entries P 2. On November 30, the end of the current fiscal year, the following infor- mation is available to assist Caruso Company’s accountants in making adjusting entries: a. Caruso Company’s Supplies account shows a beginning balance of $2,350.

Purchases during the year were $4,218. The end-of-year inventory reveals supplies on hand of $1,397.

b. The Prepaid Insurance account shows the following on November 30:

Beginning balance $4,720 July 1 4,200 October 1 7,272

The beginning balance represents the unexpired portion of a one-year policy purchased in September of the previous year. The July 1 entry repre- sents a new one-year policy, and the October 1 entry represents additional coverage in the form of a three-year policy.

c. The following table contains the cost and annual depreciation for buildings and equipment, all of which Caruso Company purchased before the current year:

Account Cost Annual Depreciation

Buildings $298,000 $16,000 Equipment 374,000 40,000

d. On September 1, the company completed negotiations with a client and accepted an advance of $18,600 for services to be performed monthly in the next year. The $18,600 was credited to Unearned Services Revenue.

e. The company calculated that as of November 30, it had earned $7,000 on an $11,000 contract that would be completed and billed in January.

f. Among the liabilities of the company is a note payable in the amount of $300,000. On November 30, the accrued interest on this note amounted to $18,000.

g. On Saturday, December 2, the company, which is on a six-day workweek, will pay its regular employees their weekly wages of $15,000.

h. On November 29, the company completed negotiations and signed a con- tract to provide services to a new client at an annual rate of $23,000.

Required 1. Prepare adjusting entries for each item listed above. 2. Explain how the conditions for revenue recognition are applied to transac-

tions e and h.

LO2 LO3

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134 CHAPTER 3 Measuring Business Income

Determining Adjusting Entries, Posting to T Accounts, and Preparing an Adjusted Trial Balance P 3. The trial balance for Prima Consultants Company on December 31, 2010, appears below. The following information is also available: a. Ending inventory of office supplies, $97 b. Prepaid rent expired, $500 c. Depreciation of office equipment for the period, $720 d. Interest accrued on the note payable, $600 e. Salaries accrued at the end of the period, $230 f. Service revenue still unearned at the end of the period, $1,410 g. Service revenue earned but not billed, $915

Required 1. Open T accounts for the accounts in the trial balance plus the following: Inter-

est Payable; Salaries Payable; Office Supplies Expense; Depreciation Expense– Office Equipment; and Interest Expense. Enter the account balances.

2. Determine the adjusting entries and post them directly to the T accounts. 3. Prepare an adjusted trial balance. 4. Which financial statements do each of the above adjustments affect? What

financial statement is not affected by the adjustments?

LO3 LO4

Prima Consultants Company Trial Balance

December 31, 2010 Cash $ 13,786 Accounts Receivable 24,840 Offi ce Supplies 991 Prepaid Rent 1,400 Offi ce Equipment 7,300 Accumulated Depreciation–Offi ce Equipment $ 2,600 Accounts Payable 1,820 Notes Payable 10,000 Unearned Service Revenue 2,860 M. Sirot, Capital 30,387 M. Sirot, Withdrawals 15,000 Service Revenue 58,500 Salaries Expense 33,400 Utilities Expense 1,750 Rent Expense 7,700 $106,167 $106,167

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Chapter Assignments 135

The following information is also available: a. To obtain space at the airport, VIP Limo paid two years’ rent in advance

when it began the business. b. An examination of insurance policies reveals that $1,800 expired during the year. c. To provide regular maintenance for the vehicles, VIP Limo deposited

$12,000 with a local garage. An examination of maintenance invoices reveals charges of $10,944 against the deposit.

d. An inventory of spare parts shows $2,016 on hand. e. VIP Limo depreciates all of its limousines at the rate of 12.5 percent per

year. No limousines were purchased during the year. f. A payment of $10,500 for one full year’s interest on notes payable is now due. g. Unearned Passenger Service Revenue on June 30 includes $17,815 for tick-

ets that employers purchased for use by their executives but which have not yet been redeemed.

Required 1. Determine the adjusting entries and enter them in the general journal (Page 14). 2. Open ledger accounts for the accounts in the trial balance plus the following:

Interest Payable (213); Rent Expense (514); Insurance Expense (515); Spare Parts Expense (516); Depreciation Expense–Limousines (517); Maintenance Expense (518); and Interest Expense (519). Record the balances shown in the trial balance.

VIP Limo Service Trial Balance

June 30, 2010 Cash (111) $ 9,812 Accounts Receivable (113) 14,227 Prepaid Rent (117) 12,000 Prepaid Insurance (118) 4,900 Prepaid Maintenance (119) 12,000 Spare Parts (140) 11,310 Limousines (148) 220,000 Accumulated Depreciation–Limousines (149) $ 35,000 Notes Payable (211) 45,000 Unearned Passenger Service Revenue (213) 30,000 A. Pham, Capital (311) 88,211 A. Pham, Withdrawals (313) 20,000 Passenger Service Revenue (411) 428,498 Gas and Oil Expense (510) 89,300 Salaries Expense (511) 206,360 Advertising Expense (516) 26,800 $626,709 $626,709

Determining Adjusting Entries and Tracing Their Effects to Financial Statements P 4. VIP Limo Service was organized to provide limousine service between the airport and various suburban locations. It has just completed its second year of business. Its trial balance is below.

LO3 LO4

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136 CHAPTER 3 Measuring Business Income

3. Post the adjusting entries from the general journal to the ledger accounts, showing proper references.

4. Prepare an adjusted trial balance, an income statement, a statement of owner’s equity, and a balance sheet. The owner made no investments during the period.

Alternate Problems Determining Adjustments P 5. At the end of its fiscal year, the trial balance for Andy’s Cleaners appears as shown below:

LO3

Andy’s Cleaners Trial Balance

September 30, 2010 Cash $ 11,788 Accounts Receivable 26,494 Prepaid Insurance 3,400 Cleaning Supplies 7,374 Land 18,000 Building 186,000 Accumulated Depreciation–Building $ 45,600 Accounts Payable 18,400 Unearned Cleaning Revenue 1,700 Mortgage Payable 110,000 A. Kopec, Capital 56,560 A. Kopec, Withdrawals 9,000 Cleaning Revenue 159,634 Wages Expense 101,330 Cleaning Equipment Rental Expense 6,100 Delivery Truck Expense 4,374 Interest Expense 11,000 Other Expenses 7,034

$391,894 $391,894

The following information is also available:

a. A study of the company’s insurance policies shows ssssthat $680 is unexpired at the end of the year.

b. An inventory of cleaning supplies shows $1,150 on hand. c. Estimated depreciation on the building for the year is $12,800. d. Accrued interest on the mortgage payable is $1,000. e. On September 1, the company signed a contract, effective immediately, with

Hope County Hospital to dry clean, for a fixed monthly charge of $425, the uniforms used by doctors in surgery. The hospital paid for four months’ ser- vice in advance.

f. Sales and delivery wages are paid on Saturday. The weekly payroll is $3,060. September 30 falls on a Thursday, and the company has a six-day pay week.

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Chapter Assignments 137

Required All adjustments affect one balance sheet account and one income statement account. For each of the above situations, show the accounts affected, the amount of the adjustment (using a � or � to indicate an increase or decrease), and the balance of the account after the adjustment in the following format: Balance Amount of Income Amount of

Sheet Adjustment Balance After Statement Adjustment Balance After Account (� or �) Adjustment Account (� or �) Adjustment

Preparing Adjusting Entries P 6. On June 30, the end of the current fiscal year, the following information is available to Conti Company’s accountants for making adjusting entries: a. Among the liabilities of the company is a mortgage payable in the amount of

$260,000. On June 30, the accrued interest on this mortgage amounted to $13,000.

b. On Friday, July 2, the company, which is on a five-day workweek and pays employees weekly, will pay its regular salaried employees $18,700.

c. On June 29, the company completed negotiations and signed a contract to provide monthly services to a new client at an annual rate of $7,200.

d. The Supplies account shows a beginning balance of $1,615 and purchases during the year of $4,115. The end-of-year inventory reveals supplies on hand of $1,318.

e. The Prepaid Insurance account shows the following entries on June 30:

Beginning balance $1,620 January 1 2,900 May 1 3,366

The beginning balance represents the unexpired portion of a one-year policy purchased in April of the previous year. The January 1 entry represents a new one-year policy, and the May 1 entry represents the additional coverage of a three-year policy.

f. The following table contains the cost and annual depreciation for buildings and equipment, all of which were purchased before the current year:

Account Cost Annual Depreciation

Buildings $170,000 $ 7,300 Equipment 218,000 20,650

g. On June 1, the company completed negotiations with another client and accepted an advance of $21,600 for services to be performed in the next year. The $21,600 was credited to Unearned Service Revenue.

h. The company calculates that as of June 30 it had earned $4,500 on a $7,500 contract that will be completed and billed in August.

Required 1. Prepare adjusting entries for each item listed above. 2. Explain how the conditions for revenue recognition are applied to transac-

tions c and h.

LO2 LO3

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138 CHAPTER 3 Measuring Business Income

Determining Adjusting Entries, Posting to T Accounts, and Preparing an Adjusted Trial Balance P 7. The trial balance for Best Advisors Service on December 31, 2011, is as follows:

LO3

The following information is also available:

a. Ending inventory of office supplies, $300 b. Prepaid rent expired, $610 c. Depreciation of office equipment for the period, $526 d. Accrued interest expense at the end of the period, $570 e. Accrued salaries at the end of the period, $330 f. Service revenue still unearned at the end of the period, $1,166 g. Service revenue earned but unrecorded, $3,100

Required 1. Open T accounts for the accounts in the trial balance plus the following:

Interest Payable; Salaries Payable; Office Supplies Expense; Depreciation Expense–Office Equipment; and Interest Expense. Enter the balances shown on the trial balance.

2. Determine the adjusting entries and post them directly to the T accounts. 3. Prepare an adjusted trial balance. 4. Which financial statements do each of the above adjustments affect? Which

financial statement is not affected by the adjustments?

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Best Advisors Service Trial Balance

December 31, 2011

Cash $ 18,500 Accounts Receivable 8,250 Offi ce Supplies 2,662 Prepaid Rent 1,320 Offi ce Equipment 9,240 Accumulated Depreciation– Offi ce Equipment $ 1,540 Accounts Payable 5,940 Notes Payable 11,000 Unearned Service Revenue 2,970 M. Dabrowska, Capital 26,002 M. Dabrowska, Withdrawals 22,000 Service Revenue 72,600 Salaries Expense 49,400 Rent Expense 4,400 Utilities Expense 4,280 $120,052 $120,052

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Chapter Assignments 139

Determining Adjusting Entries and Tracing Their Effects to Financial Statements P 8. Helen Ortega opened a small tax-preparation service. At the end of its second year of operation, Ortega Tax Service had the trial balance that appears below.

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Ortega Tax Service Trial Balance

December 31, 2010

Cash $ 3,700 Accounts Receivable 1,099 Prepaid Insurance 240 Offi ce Supplies 780 Offi ce Equipment 7,100 Accumulated Depreciation– Offi ce Equipment $ 770 Accounts Payable 635 Unearned Tax Fees 219 H. Ortega, Capital 6,939 H. Ortega, Withdrawals 6,000 Tax Fees Revenue 21,926 Offi ce Salaries Expense 8,300 Advertising Expense 650 Rent Expense 2,400 Telephone Expense 220 $30,489 $30,489

The following information is also available:

a. Office supplies on hand, December 31, 2010, $225. b. Insurance still unexpired, $100. c. Estimated depreciation of office equipment, $795. d. Telephone expense for December, $21; the bill was received but not recorded. e. The services for all unearned tax fees had been performed by the end of the year.

Required 1. Open T accounts for the accounts in the trial balance plus the following:

Office Supplies Expense; Insurance Expense; and Depreciation Expense– Office Equipment. Record the balances shown in the trial balance.

2. Determine the adjusting entries and post them directly to the T accounts. 3. Prepare an adjusted trial balance, an income statement, a statement of owner’s

equity, and a balance sheet. The owner made no investments during the period. 4. Why is it not necessary to show the effects of the above transactions on the

statement of cash flows?

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140 CHAPTER 3 Measuring Business Income

Importance of Adjustments C 1. Never Flake Company, which operated in the northeastern part of the United States, provided a rust-prevention coating for the underside of new automobiles. The company advertised widely and offered its services through new car dealers. When a dealer sold a new car, the salesperson attempted to sell the rust-preven- tion coating as an option. The protective coating was supposed to make cars last longer in the severe northeastern winters. A key selling point was Never Flake’s warranty, which stated that it would repair any damage due to rust at no charge for as long as the buyer owned the car.

For several years, Never Flake had been very successful in generating enough cash to continue operations. But in 2011, the company suddenly declared bank- ruptcy. Company officials said that the firm had only $5.5 million in assets against liabilities of $32.9 million. Most of the liabilities represented potential claims under the company’s lifetime warranty. It seemed that owners were keeping their cars longer now than previously. Therefore, more damage was being attributed to rust. Discuss what accounting decisions could have helped Never Flake survive under these circumstances.

Earnings Management and Fraudulent Financial Reporting C 2. In recent years, the Securities and Exchange Commission (SEC) has been waging a public campaign against corporate accounting practices that manage or manipulate earnings to meet the expectations of Wall Street analysts. Corpora- tions engage in such practices in the hope of avoiding shortfalls that might cause serious declines in their stock price. For each of the following cases that the SEC challenged, tell why each is a violation of the matching rule and how it should be accounted for: a. Lucent Technologies sold telecommunications equipment to companies

from which there was no reasonable expectation of payment because of the companies’ poor financial condition.

b. America Online (AOL) recorded advertising as an asset rather than as an expense.

c. Eclipsys recorded software contracts as revenue even though it had not yet rendered the services.

d. KnowledgeWare recorded revenue from sales of software even though it told customers they did not have to pay until they had the software.

Analysis of an Asset Account C 3. The Walt Disney Company is engaged in the financing, production, and distribution of motion pictures and television programming. In Disney’s 2008 annual report, the balance sheet contained an asset called “film and tele- vision costs.” Film and television costs, which consist of the costs associated with producing films and television programs less the amount expensed, were $5,394,000,000. The estimated amount of film and television costs expensed (amortized) during the next year were $3,500,000,000. The amount estimated to be spent for new film productions was $2,900,000,000. 1. What are film and television costs, and why would they be classified as an

asset? 2. Prepare an entry in T account form to record the amount the company spent

on new film and television productions during 2010 (assume all expenditures are paid for in cash).

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Chapter Assignments 141

3. Prepare an adjusting entry in T account form to record the expense for film and television productions during 2009. Show the balance of the Film and Television Costs account at the end of the next year.

4. Suggest a method by which The Walt Disney Company might have deter- mined the amount of the expense in 3 in accordance with the matching rule.

Importance of Adjustments C 4. Main Street Service Co. has achieved fast growth in the St. Louis area by sell- ing service contracts on large appliances, such as washers, dryers, and refrigera- tors. For a fee, Main Street agrees to provide all parts and labor on an appliance after the regular warranty runs out. For example, by paying a fee of $200, a person who buys a dishwasher can add two years (years 2 and 3) to the regular one-year (year 1) warranty on the appliance. In 2009, the company sold service contracts in the amount of $1.8 million, all of which applied to future years. Management wanted all the sales recorded as revenues in 2009, contending that the amount of the contracts could be determined and the cash had been received. Discuss whether you agree with this logic. How would you record the cash receipts? What assumptions do you think Main Street should make? Would you consider it unethical to follow management’s recommendation? Who might be hurt or helped by this action?

Real-World Observation of Business Activities C 5. Visit a company with which you are familiar and observe its opera- tions. (The company can be where you work, where you eat, or where you buy things.) Identify at least two sources of revenue for the company and six types of expenses. For each type of revenue and each type of expense, determine whether it is probable that an adjusting entry is required at the end of the accounting period. Then specify the adjusting entry as a deferred revenue, deferred expense, accrued revenue, or accrued expense. Design a table with columns and rows that summarizes your results in an easy-to- understand format.

Analysis of Balance Sheet and Adjusting Entries C 6. In CVS Corporation’s annual report in the Supplement to Chapter 5, refer to the balance sheet and the Summary of Significant Accounting Policies in the notes to the financial statements. a. Examine the accounts in the current assets, property and equipment, and

current liabilities sections of CVS’s balance sheet. Which are most likely to have had year-end adjusting entries? Describe the nature of the adjusting entries. For more information about the property and equipment section, refer to the notes to the financial statements.

b. Where is depreciation (and amortization) expense disclosed in CVS’s finan- cial statements?

c. CVS has a statement on the “Use of Estimates” in its Summary of Signifi- cant Accounting Policies. Read this statement and tell how important esti- mates are to the determination of depreciation expense. What assumptions do accountants make that allow these estimates to be made?

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