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Chapter3 Adjusting the Accounts

Scan Study Objectives ■

Read Feature Story ■

Read Preview ■

Read text and answer Before You Go On p. 97 ■ p. 104 ■ p. 109 ■ p. 114 ■

Work Demonstration Problem ■

Review Summary of Study Objectives ■

Answer Self-Study Questions ■

Complete Assignments ■

After studying this chapter, you should be able to: 1 Explain the time period assumption. 2 Explain the accrual basis of accounting. 3 Explain the reasons for adjusting entries. 4 Identify the major types of adjusting

entries. 5 Prepare adjusting entries for deferrals. 6 Prepare adjusting entries for accruals. 7 Describe the nature and purpose of an

adjusted trial balance.

The NavigatorS T U D Y O B J E C T I V E S ✓

Feature Story WHAT WAS YOUR PROFIT?

The accuracy of the financial reporting system depends on answers to a few fundamental questions: At what point has revenue been earned? At what point is the earnings process complete? When have expenses really been incurred?

During the 1990s’ boom in the stock prices of dot-com companies, many dot-coms earned most of their revenue from selling advertising space on their websites. To boost reported revenue, some dot-coms began swapping website ad space. Company A would put an ad for its website on company B’s website, and company B would put an ad for its website on company A’s website. No money changed hands, but each company recorded revenue (for the value of the space that it gave the other company on its site). This practice did little to boost net income, and it resulted in no additional cash flow—but it did boost reported revenue. Regulators eventually put an end to this misleading practice.

The Navigator✓

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Another type of transgression results from companies record- ing revenues or expenses in the wrong year. In fact, shifting revenues and expenses is one of the most common abuses of financial accounting. Xerox, for example, admitted reporting billions of dollars of lease rev- enue in periods earlier than it should have been reported. And WorldCom stunned the financial markets with its admis- sion that it had boosted net income by billions of dollars by delaying the recognition of expenses until later years.

Unfortunately, revelations such as these have become all too common in the corporate world. It is no wonder that a U.S. Trust survey of affluent Ameri- cans reported that 85% of respondents believed that there should be tighter regulation of financial disclosures; 66% said they did not trust the manage- ment of publicly traded companies.

Why did so many companies violate basic financial reporting rules and sound ethics? Many speculate that as stock prices climbed, executives were under increasing pressure to meet higher and higher earnings expectations. If actual results weren’t as good as hoped for, some gave in to temptation and “adjusted” their numbers to meet market expectations.

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Inside Chapter 3 • How Long Will “The Force” Be with Us? (p. 96)

• Companies Change Advertising Treatment (p. 100)

• Turning Gift Cards into Revenue (p. 104)

• All About You: Is Your Old Computer a Liability? (p. 115)

Preview of Chapter 3 In Chapter 1 you learned a neat little formula: Net income � Revenues � Expenses. In Chapter 2 you learned some rules for recording revenue and expense transactions. Guess what? Things are not really that nice and neat. In fact, it is often difficult for companies to determine in what time period they should report some revenues and expenses. In other words, in measuring net income, timing is everything.

The content and organization of Chapter 3 are as follows.

Adjusting the Accounts

Timing Issues

• Time period assumption • Fiscal and calendar years • Accrual- vs. cash-basis accounting • Recognizing revenues and expenses

The Adjusted Trial Balance and Financial Statements

• Preparing the adjusted trial balance • Preparing financial statements

The Basics of Adjusting Entries

• Types of adjusting entries • Adjusting entries for deferrals • Adjusting entries for accruals • Summary of journalizing and posting

The Navigator✓

TIMING ISSUES We would need no adjustments if we could wait to prepare financial state- ments until a company ended its operations. At that point, we could easily determine its final balance sheet and the amount of lifetime income it earned.The following story illustrates one way to compute lifetime income.

A grocery store owner from the “old country” kept his accounts payable on a spindle, accounts receivable on a note pad, and cash in a cigar box. His daughter, having just passed the CPA exam, chided the father: “I don’t understand how you can run your business this way. How do you know what your profits are?”

“Well,” the father replied, “when I got off the boat 40 years ago, I had nothing but the pants I was wearing. Today your brother is a doctor, your sis- ter is a college professor, and you are a CPA. Your mother and I have a nice car, a well-furnished house, and a lake home. We have a good business, and everything is paid for. So, you add all that together, subtract the pants, and there’s your profit.”

Selecting an Accounting Time Period Although the old grocer may be correct in his evaluation, it is impractical to wait so long for the results of operations. All companies find it desirable to report the results of their activities on a frequent basis. For example, management usually wants monthly financial statements, and the Internal Revenue Service requires all businesses to file annual tax returns. Therefore, accountants divide the economic life of a business into artificial time periods.This convenient assumption is referred to as the time period assumption.

Many business transactions affect more than one of these arbitrary time peri- ods. For example, the airplanes purchased by Northwest Air Lines five years ago are still in use today.We must determine the relevance of each business transaction to specific accounting periods. (How much of the cost of an airplane contributed to operations this year?)

Explain the time period assumption.

S T U D Y O B J E C T I V E 1

Time Period Assumption

Year 1 Year 10

Year 6

A L T E R N A T I V E T E R M I N O L O G Y

The time period assump- tion is also called the periodicity assumption.

94

Fiscal and Calendar Years Both small and large companies prepare financial statements periodically in order to assess their financial condition and results of operations. Accounting time peri- ods are generally a month, a quarter, or a year. Monthly and quarterly time periods are called interim periods. Most large companies must prepare both quarterly and annual financial statements.

An accounting time period that is one year in length is a fiscal year. A fiscal year usually begins with the first day of a month and ends twelve months later on the last day of a month. Most businesses use the calendar year (January 1 to December 31) as their accounting period. Some do not. Companies whose fiscal year differs from the calendar year include Delta Air Lines, June 30, and Walt Disney Productions, September 30. Sometimes a company’s year-end will vary from year to year. For example, PepsiCo’s fiscal year ends on the Friday closest to December 31, which was December 25 in 2004 and December 30 in 2005.

Accrual- vs. Cash-Basis Accounting What you will learn in this chapter is accrual-basis accounting. Under the accrual basis, companies record transactions in the periods in which the events occur. For example, using the accrual basis to determine net income means companies recognize revenues when earned (rather than when they receive cash). It also means recognizing expenses when incurred (rather than when paid).

An alternative to the accrual basis is the cash basis. Under cash-basis account- ing, companies record revenue when they receive cash. They record an expense when they pay out cash. The cash basis seems appealing due to its simplicity, but it often produces misleading financial statements. It fails to record revenue that a company has earned but for which it has not received the cash. Also, it does not match expenses with earned revenues. Cash-basis accounting is not in accordance with generally accepted accounting principles (GAAP).

Individuals and some small companies do use cash-basis accounting. The cash basis is justified for small businesses because they often have few receivables and payables. Medium and large companies use accrual-basis accounting.

Recognizing Revenues and Expenses It can be difficult to determine the amount of revenues and expenses to report in a given accounting period. Two principles help in this task: the revenue recognition principle and the matching principle.

REVENUE RECOGNITION PRINCIPLE The revenue recognition principle dictates that companies recognize revenue in the accounting period in which it is earned. In a service enterprise, revenue is con- sidered to be earned at the time the service is performed. To illustrate, assume that Dave’s Dry Cleaning, Inc. cleans clothing on June 30 but customers do not claim and pay for their clothes until the first week of July. Under the revenue recognition principle, Dave’s earns revenue in June when it performed the service, rather than in July when it received the cash. At June 30, Dave’s would report a receivable on its balance sheet and revenue in its income statement for the service performed.

MATCHING PRINCIPLE Accountants follow a simple rule in recognizing expenses: “Let the expenses follow the revenues.” That is, expense recognition is tied to revenue recognition. In the dry cleaning example, this principle means that Dave’s should report the salary

Timing Issues 95

Explain the accrual basis of accounting

S T U D Y O B J E C T I V E 2

Cash received

Customer requests service

Service performed

Revenue Recognition

Matching Revenues

Expenses

Advertising

Delivery

Utilities

expense incurred in performing the June 30 cleaning service in the income state- ment for the same period in which it recognizes the service revenue. The critical is- sue in expense recognition is when the expense makes its contribution to revenue. This may or may not be the same period in which the expense is paid. If Dave’s does not pay the salary incurred on June 30 until July, it would report salaries payable on its June 30 balance sheet.

This practice of expense recognition is referred to as the matching principle. It dictates that efforts (expenses) be matched with accomplishments (revenues). Illustration 3-1 summarizes the revenue and expense recognition principles.

96 Chapter 3 Adjusting the Accounts

ACCOUNTING ACROSS THE ORGANIZATION How Long Will “The Force” Be with Us?

Suppose you are filmmaker George Lucas and you spent $11 million to produce Twentieth Century Fox’s film Star Wars. Over what period should the studio ex-

pense the cost? Yes, it should expense the cost over the economic life of the film. But what is its eco-

nomic life? You must estimate how much revenue you will earn from box office sales, video sales, television, and games and toys—a period that could be less than a year or more than 20 years, as is the case for Star Wars. Originally released in 1977, and rereleased in 1997, do- mestic revenues total over $500 million for Star Wars and continue to grow.

What accounting principle does this example illustrate? How will financial results be affected if the expenses are recognized over a period that is less than that used for revenues? What

if the expenses are recognized over a period that is longer than that used for revenues?

Revenue and Expense Recognition

In accordance with generally accepted accounting principles

(GAAP).

Matching Principle

Match expenses with revenues in the period when the company makes

efforts to generate those revenues.

Time Period Assumption

Economic life of business can be divided into

artificial time periods.

Revenue Recognition Principle

Recognize revenue in the accounting period in

which it is earned.

Illustration 3-1 GAAP relationships in revenue and expense recognition

The Basics of Adjusting Entries 97

REVIEW IT 1. What is the relevance of the time period assumption to accounting? 2. What are the revenue recognition and matching principles?

Before You Go On...

The Navigator✓

THE BASICS OF ADJUSTING ENTRIES In order for revenues and expenses to be reported in the correct period, companies make adjusting entries at the end of the accounting period. Adjusting entries ensure that the revenue recognition and matching prin- ciples are followed. Adjusting entries make it possible to report correct amounts on the balance sheet and on the income statement.

The trial balance—the first summarization of the transaction data—may not contain up-to-date and complete data. This is true for several reasons:

1. Some events are not recorded daily because it is not efficient to do so. For example, companies do not record the daily use of supplies or the earning of wages by employees.

2. Some costs are not recorded during the accounting period because they expire with the passage of time rather than as a result of daily transactions. Examples are rent, insurance, and charges related to the use of equipment.

3. Some items may be unrecorded. An example is a utility bill that the company will not receive until the next accounting period.

A company must make adjusting entries every time it prepares financial state- ments. It analyzes each account in the trial balance to determine whether it is com- plete and up-to-date. For example, the company may need to make inventory counts of supplies. It may also need to prepare supporting schedules of insurance policies, rental agreements, and other contractual commitments. Because the ad- justing and closing process can be time-consuming, companies often prepare adjusting entries after the balance sheet date, but date them as of the balance sheet date.

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

Explain the reasons for adjusting entries.

S T U D Y O B J E C T I V E 3

Identify the major types of adjusting entries.

S T U D Y O B J E C T I V E 4

Accounting Cycle Tutorial— Making Adjusting Entries

H E L P F U L H I N T

Adjusting entries are needed to enable finan- cial statements to conform to GAAP.

Deferrals 1. Prepaid Expenses. Expenses paid in cash and recorded as assets before they are

used or consumed.

2. Unearned Revenues. Cash received and recorded as liabilities before revenue is earned.

Accruals 1. Accrued Revenues. Revenues earned but not yet received in cash or recorded. 2. Accrued Expenses. Expenses incurred but not yet paid in cash or recorded.

Illustration 3-2 Categories of adjusting entries

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w

.wiley.co

m /c

o ll

e g

e/ we

ygandt

We assume that Pioneer Advertising uses an accounting period of one month, and thus it makes monthly adjusting entries. The entries are dated October 31.

Adjusting Entries for Deferrals Deferrals are either prepaid expenses or unearned revenues. Companies make adjustments for deferrals to record the portion of the deferral that represents the expense incurred or the revenue earned in the current period.

PREPAID EXPENSES Companies record payments of expenses that will benefit more than one account- ing period as assets called prepaid expenses or prepayments. When expenses are prepaid, an asset account is increased (debited) to show the service or benefit that the company will receive in the future. Examples of common prepayments are insurance, supplies, advertising, and rent. In addition, companies make prepay- ments when they purchase buildings and equipment.

Prepaid expenses are costs that expire either with the passage of time (e.g., rent and insurance) or through use (e.g., supplies). The expiration of these costs does not require daily journal entries. Companies postpone recognizing these costs until they prepare financial statements. At each statement date, they make adjusting entries: (1) to record the expenses that apply to the current accounting period, and (2) to show the unexpired costs in the asset accounts.

Prior to adjustment for prepaid expenses, assets are overstated and expenses are understated. As shown in Illustration 3-4, an adjusting entry for prepaid expense increases (debits) an expense account and a decreases (credits) an asset account.

98 Chapter 3 Adjusting the Accounts

Prepare adjusting entries for deferrals.

S T U D Y O B J E C T I V E 5

The following pages explain each type of adjustment and show examples. Each example is based on the October 31 trial balance of Pioneer Advertising Agency Inc. from Chapter 2 and reproduced in Illustration 3-3.

PIONEER ADVERTISING AGENCY INC. Trial Balance

October 31, 2008

Debit Credit Cash $15,200 Advertising Supplies 2,500 Prepaid Insurance 600 Office Equipment 5,000 Notes Payable $ 5,000 Accounts Payable 2,500 Unearned Revenue 1,200 Common Stock 10,000 Retained Earnings –0– Dividends 500 Service Revenue 10,000 Salaries Expense 4,000 Rent Expense 900

$28,700 $28,700

Illustration 3-3 Trial balance

On the next few pages, we will look in more detail at some specific types of pre- paid expenses, beginning with supplies.

Supplies. Businesses use various types of supplies such as paper, envelopes, and printer cartridges. Companies generally debit supplies to an asset account when they acquire them. In the course of operations, supplies are used, but companies postpone recognizing their use until the adjustment process. At the end of the accounting period, a company counts the remaining supplies. The difference be- tween the balance in the Supplies (asset) account and the supplies on hand repre- sents the supplies used (an expense) for the period.

Pioneer Advertising Agency Inc. purchased advertising supplies costing $2,500 on October 5. Pioneer recorded that transaction by increasing (debiting) the as- set Advertising Supplies. This account shows a balance of $2,500 in the October 31 trial balance. An inventory count at the close of business on October 31 re- veals that $1,000 of supplies are still on hand. Thus, the cost of supplies used is $1,500 ($2,500 � $1,000). Pioneer makes the following adjusting entry.

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

(To record supplies used)

After the adjusting entry is posted, the two supplies accounts show:

The Basics of Adjusting Entries 99

Prepaid Expenses

Asset

Credit Adjusting Entry (–)

Unadjusted Balance

Expense

Debit Adjusting Entry (+)

Illustration 3-4 Adjusting entries for prepaid expenses

A � L � SE �1,500 Exp

�1,500

Cash Flows no effect

Equation analyses summarize the effects of the transaction on the elements of the accounting equation.

Advertising Supplies Advertising Supplies Expense

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

10/31 Bal. 1,000

Illustration 3-5 Supplies accounts after adjustment

The asset account Advertising Supplies now shows a balance of $1,000, which is equal to the cost of supplies on hand at the statement date. In addition, Advertising Supplies Expense shows a balance of $1,500, which equals the cost of supplies used in October. If Pioneer does not make the adjusting entry, October expenses will be understated and net income overstated by $1,500. Also, both assets and owner’s equity will be overstated by $1,500 on the October 31 balance sheet.

Supplies used; record supplies expense

Supplies purchased; record asset

Oct. 31

Oct. 5

Supplies

Pioneer Advertising

Agency

Insurance. Companies purchase insurance to protect themselves from losses due to fire, theft, and other unforeseen events. Insurance must be paid in advance. Insurance premiums (payments) normally are recorded as an increase (a debit) to the asset account Prepaid Insurance.At the financial statement date companies in- crease (debit) Insurance Expense and decrease (credit) Prepaid Insurance for the cost that has expired during the period.

On October 4, Pioneer Advertising Agency Inc. paid $600 for a one-year fire insurance policy. Coverage began on October 1. Pioneer recorded the payment by increasing (debiting) Prepaid Insurance. This account shows a balance of $600 in the October 31 trial balance. Insurance of $50 ($600 � 12) expires each month. Thus, Pioneer makes the following adjusting entry.

Oct. 31 Insurance Expense 50 Prepaid Insurance 50

(To record insurance expired)

After Pioneer posts the adjusting entry, the accounts show:

100 Chapter 3 Adjusting the Accounts

Insurance expired; record insurance expense

Insurance purchased; record asset

Oct. 4

Oct. 31

Insurance

Insurance Policy Nov $50

Dec $50

Jan $50

Feb $50

March $50

April $50

May $50

June $50

July $50

Aug $50

Sept $50

1 YEAR $600

Oct $50

Prepaid Insurance Insurance Expense

10/4 600 10/31 Adj. 50 10/31 Adj. 50

10/31 Bal. 550

Illustration 3-6 Insurance accounts after adjustment

The asset Prepaid Insurance shows a balance of $550. This amount represents the unexpired cost for the remaining 11 months of coverage. The $50 balance in Insurance Expense equals the insurance cost that has expired in October. If Pioneer does not make this adjustment, October expenses will be understated and net income overstated by $50. Also, both assets and stockholders’ equity will be overstated by $50 on the October 31 balance sheet.

ACCOUNTING ACROSS THE ORGANIZATION Companies Change Advertising Treatment

The method of accounting for advertising costs affects sales and marketing executives. In the past, companies sometimes recorded as assets the costs of

media advertising for burgers, bleaches, athletic shoes, and other products. They then expensed those costs in subsequent periods as sales took place. The reasoning behind this treatment was that long ad campaigns provided benefits over multiple accounting periods. Today the accounting profession no longer allows this treatment because it decided that the benefits were too difficult to measure.

Instead, companies now must expense advertising costs when the advertising takes place. The issue is important because the outlays for advertising can be substantial. Recent big spenders: The Coca-Cola Company spent $2.2 billion, PepsiCo., Inc. $1.7 billion, Nike, Inc. $1,378 million, and Limited Brands $484 million.

Why might the new accounting method cause companies sometimes to spend less on advertising?

A � L � SE �50 Exp

�50

Cash Flows no effect

Depreciation. Companies typically own buildings, equipment, and vehicles. These long-lived assets provide service for a number of years. Thus, each is recorded as an asset, rather than an expense, in the year it is acquired.As explained in Chapter 1, companies record such assets at cost, as required by the cost princi- ple. The term of service is referred to as the useful life.

According to the matching principle, companies then report a portion of the cost of a long-lived asset as an expense during each period of the asset’s useful life. Depreciation is the process of allocating the cost of an asset to expense over its use- ful life in a rational and systematic manner.

Need for Depreciation Adjustment. From an accounting standpoint, acquiring long-lived assets is essentially a long-term prepayment for services. Companies need to make periodic adjusting entries for depreciation, just as they do for other prepaid expenses. These entries recognize the cost that has been used (an expense) during the period and report the unexpired cost (an asset) at the end of the period.

When a company acquires a long-lived asset, it does not know its exact useful life. The asset may be useful for a longer or shorter time than expected, depending on various factors. Thus, depreciation is an estimate rather than a factual measure- ment of expired cost. A common procedure in computing depreciation expense is to divide the cost of the asset by its useful life. For example, if cost is $10,000 and useful life is expected to be 10 years, annual depreciation is $1,000.1

Pioneer Advertising estimates depreciation on the office equipment to be $480 a year, or $40 per month. Thus, Pioneer makes the following adjusting entry to record depreciation for October.

Oct. 31 Depreciation Expense 40 Accumulated Depreciation—Office Equipment 40

(To record monthly depreciation)

After the adjusting entry is posted, the accounts show:

The Basics of Adjusting Entries 101

Office Equipment 10/1 5,000

Accumulated Depreciation— Office Equipment Depreciation Expense

10/31 Adj. 40 10/31 Adj. 40

Illustration 3-7 Accounts after adjustment for depreciation

Cash Flows no effect

A � L � SE �40 Exp

�40

H E L P F U L H I N T All contra accounts have increases, decreases, and normal balances opposite to the account to which they relate.

Depreciation recognized; record depreciation expense

Office equipment purchased; record asset

Oct. 2

Oct. 31

Depreciation

Office Equipment Oct $40

Nov $40

Dec $40

Jan $40

Feb $40

March $40

April $40

May $40

June $40

July $40

Aug $40

Sept $40

Depreciation = $480/year

The balance in the accumulated depreciation account will increase $40 each month.After journalizing and posting the adjusting entry at November 30, the bal- ance will be $80; at December 31, $120; and so on.

Statement Presentation. Accumulated Depreciation—Office Equipment is a contra asset account. That means that it is offset against an asset account on the balance sheet. This accumulated depreciation account appears just after the account it offsets (in this case, Office Equipment) on the balance sheet. Its normal balance is a credit.

An alternative to using a contra asset account would be to decrease (credit) the asset account (e.g., Office Equipment) directly for the depreciation each month. But use of the contra account is preferable for a simple reason: it discloses both the original cost of the equipment and the total cost that has expired to date.

1Chapter 10 addresses the computation of depreciation expense in detail.

In the balance sheet, Pioneer deducts Accumulated Depreciation—Office Equipment from the related asset account, as follows.

102 Chapter 3 Adjusting the Accounts

ACCOUNTING FOR PREPAID EXPENSES

Reason for Accounts Before Adjusting Examples Adjustment Adjustment Entry

Insurance, supplies, Prepaid expenses Assets over- Dr. Expenses advertising, rent, recorded in asset stated. Cr. Assets depreciation. accounts have Expenses

been used. understated.

Illustration 3-9 Accounting for prepaid expenses

Some service has been provided; some revenue

is recorded

Cash is received in advance; liability is recorded

Oct. 2

Oct. 31

Unearned Revenues

Thank you in advance for

your work

I will finish by Dec. 31

$1,200

Office equipment $5,000 Less: Accumulated depreciation—office equipment 40 $4,960

Illustration 3-8 Balance sheet presentation of accumulated depreciation

The difference between the cost of any depreciable asset and its related accu- mulated depreciation is its book value. In Illustration 3-8, the book value of the equipment at the balance sheet date is $4,960.The book value of an asset generally differs from its market value—the price at which the asset could be sold in the mar- ketplace. Remember that depreciation is a means of cost allocation, not a matter of market valuation.

Depreciation expense identifies that portion of the asset’s cost that has expired during the period (in this case, in October). As for other prepaid adjustments, the omission of this adjusting entry would cause total assets, total owner’s equity, and net income to be overstated and depreciation expense to be understated.

If the company owns additional long-lived assets, such as store equipment or buildings, it records depreciation expense on each of those items. It also establishes related accumulated depreciation accounts, such as: Accumulated Depreciation— Store Equipment; and Accumulated Depreciation—Buildings.

Illustration 3-9 summarizes the accounting for prepaid expenses.

UNEARNED REVENUES Companies record cash received before revenue is earned by increasing a liability account called unearned revenues. Examples are rent, magazine subscriptions, and customer deposits for future service.Airlines such as United, American, and Delta, for instance, treat receipts from the sale of tickets as unearned revenue until they provide the flight service. Similarly, colleges consider tuition received prior to the start of a semester as unearned revenue.

Unearned revenues are the opposite of prepaid expenses. Indeed, unearned revenue on the books of one company is likely to be a prepayment on the books of the company that made the advance payment. For example, a landlord will have unearned rent revenue when a tenant has prepaid rent.

When a company receives cash for future services, it increases (credits) an unearned revenue account (a liability) to recognize the liability. Later, the com- pany earns revenues by providing service. It may not be practical to make daily journal entries as the revenue is earned. Instead, we delay recognizing earned rev- enue until the end of the period. Then the company makes an adjusting entry to record the revenue that has been earned and to show the liability that remains. Typically, prior to adjustment, liabilities are overstated and revenues are under- stated. Therefore, as shown in Illustration 3-10, the adjusting entry for unearned revenues results in a decrease (a debit) to a liability account and an increase (a credit) to a revenue account.

A L T E R N A T I V E T E R M I N O L O G Y

Book value is sometimes referred to as carrying value or unexpired cost.

The Basics of Adjusting Entries 103

Unearned Revenue Service Revenue

10/31 Adj. 400 10/2 1,200 10/31 Bal. 10,000

10/31 Bal. 800 31 Adj. 400

Illustration 3-11 Revenue accounts after prepayments adjustment

Cash Flows no effect

A � L � SE �400

�400 Rev

The liability Unearned Revenue now shows a balance of $800. That amount represents the remaining prepaid advertising services to be performed in the future. At the same time, Service Revenue shows total revenue of $10,400 earned in October. Without this adjustment, revenues and net income are understated by $400 in the income statement. Also, liabilities are overstated and stockholders’ equity understated by $400 on the October 31 balance sheet.

Illustration 3-12 summarizes the accounting for unearned revenues.

Pioneer Advertising Agency Inc. received $1,200 on October 2 from R. Knox for advertising services expected to be completed by December 31. Pioneer cred- ited the payment to Unearned Service Revenue; this account shows a balance of $1,200 in the October 31 trial balance. Analysis reveals that the company earned $400 of those fees in October. Thus, it makes the following adjusting entry.

Oct. 31 Unearned Revenue 400 Service Revenue 400

(To record revenue for services provided)

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

A L T E R N A T I V E T E R M I N O L O G Y

Unearned revenue is sometimes referred to as deferred revenue.

Unearned Revenues

Liability Revenue

Credit Adjusting Entry (+)

Debit Adjusting Entry (–)

Unadjusted Balance

Illustration 3-10 Adjusting entries for unearned revenues

Illustration 3-12 Accounting for unearned revenues

ACCOUNTING FOR UNEARNED REVENUES

Reason for Accounts Before Adjusting Examples Adjustment Adjustment Entry

Rent, magazine Unearned revenues Liabilities Dr. Liabilities subscriptions, recorded in liability overstated. Cr. Revenues customer deposits accounts have been Revenues for future service. earned. understated.

104 Chapter 3 Adjusting the Accounts

ACCOUNTING ACROSS THE ORGANIZATION Turning Gift Cards into Revenue

Those of you interested in marketing know that gift cards are among the hottest tools in merchandising today. Customers purchase gift cards and give them to

someone for later use. In a recent year gift-card sales topped $95 billion. Although these programs are popular with marketing executives, they create accounting

questions. Should revenue be recorded at the time the gift card is sold, or when it is used by the customer? How should expired gift cards be accounted for? In its 2004 balance sheet Best Buy reported unearned revenue related to gift cards of $300 million.

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

Suppose that Robert Jones purchases a $100 gift card at Best Buy on December 24, 2007, and gives it to his wife, Devon, on December 25, 2007. On January 3, 2008,

Devon uses the card to purchase $100 worth of CDs. When do you think Best Buy should rec- ognize revenue, and why?

REVIEW IT 1. What are the four types of adjusting entries? 2. What is the effect on assets, stockholders’ equity, expenses, and net income if

a company does not make a prepaid expense adjusting entry? 3. What is the effect on liabilities, stockholders’ equity, revenues, and net income

if a company does not make an unearned revenue adjusting entry? 4. Using PepsiCo’s Consolidated Statement of Income, what was the amount of

depreciation expense for 2005 and 2004? (See Note 4 to the financial state- ments.) The answer to this question appears on page 140.

DO IT The ledger of Hammond, Inc. on March 31, 2008, includes the following selected accounts before adjusting entries.

Debit Credit Prepaid Insurance 3,600 Office Supplies 2,800 Office Equipment 25,000 Accumulated Depreciation—Office Equipment 5,000 Unearned Revenue 9,200

An analysis of the accounts shows the following. 1. Insurance expires at the rate of $100 per month. 2. Supplies on hand total $800. 3. The office equipment depreciates $200 a month. 4. One-half of the unearned revenue was earned in March. Prepare the adjusting entries for the month of March.

Action Plan ■ Make adjusting entries at the end of the period for revenues earned and

expenses incurred in the period.

Before You Go On...

The Basics of Adjusting Entries 105

Cash is received; receivable is reduced

Revenue and receivable are recorded for unbilled services

Oct. 31

Nov. 10

Accrued Revenues

My fee is $200

$

Adjusting Entries for Accruals The second category of adjusting entries is accruals. Companies make adjusting entries for accruals to record revenues earned and expenses incurred in the current accounting period that have not been recognized through daily entries.

ACCRUED REVENUES Revenues earned but not yet recorded at the statement date are accrued revenues. Accrued revenues may accumulate (accrue) with the passing of time, as in the case of interest revenue and rent revenue. Or they may result from services that have been performed but are neither billed nor collected. The former are unrecorded because the earning process (e.g., of interest and rent) does not involve daily trans- actions. The latter may be unrecorded because the company has provided only a portion of the total service.

An adjusting entry for accrued revenues serves two purposes: (1) It shows the receivable that exists at the balance sheet date, and (2) it records the revenues earned during the period. Prior to adjustment, both assets and revenues are under- stated. Therefore, as Illustration 3-13 shows, an adjusting entry for accrued rev- enues increases (debits) an asset account and increases (credits) a revenue account.

■ Don’t forget to make adjusting entries for prepayments. Failure to adjust for prepayments leads to overstatement of the asset or liability and related understatement of the expense or revenue.

Solution 1. Insurance Expense 100

Prepaid Insurance 100 (To record insurance expired)

2. Office Supplies Expense 2,000 Office Supplies 2,000

(To record supplies used)

3. Depreciation Expense 200 Accumulated Depreciation—Office Equipment 200

(To record monthly depreciation)

4. Unearned Revenue 4,600 Service Revenue 4,600

(To record revenue for services provided)

Related exercise material: BE3-3, BE3-4, BE3-5, and BE3-6.

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Accrued Revenues

Asset Revenue

Debit Adjusting Entry (+)

Credit Adjusting Entry (+)

Illustration 3-13 Adjusting entries for accrued revenues

Prepare adjusting entries for accruals.

S T U D Y O B J E C T I V E 6

In October Pioneer Advertising Agency Inc. earned $200 for advertising serv- ices that have not been recorded. Pioneer makes the following adjusting entry on October 31.

Oct. 31 Accounts Receivable 200 Service Revenue 200

(To record revenue for services provided)

After Pioneer posts the adjusting entry, the accounts show:

106 Chapter 3 Adjusting the Accounts

A L T E R N A T I V E T E R M I N O L O G Y

Accrued expenses are also called accrued liabilities.

Illustration 3-15 Accounting for accrued revenues

ACCOUNTING FOR ACCRUED REVENUES

Reason for Accounts Before Adjusting Examples Adjustment Adjustment Entry

Interest, rent, Revenues have been Assets under- Dr. Assets services performed earned but not yet stated. Cr. Revenues but not collected. received in cash Revenues

or recorded. understated.

The asset Accounts Receivable indicates that clients owe $200 at the balance sheet date. The balance of $10,600 in Service Revenue represents the total revenue Pioneer earned during the month ($10,000 � $400 � $200). Without the adjusting entry, assets and stockholders’ equity on the balance sheet, and revenues and net income on the income statement, are understated.

On November 10, Pioneer receives cash of $200 for the services per- formed in October and makes the following entry.

Nov. 10 Cash 200 Accounts Receivable 200

(To record cash collected on account)

The company records collection of cash on account with a debit (increase) to Cash and a credit (decrease) to Accounts Receivable.

Illustration 3-15 summarizes the accounting for accrued revenues.

Accounts Receivable Service Revenue 10/31 Adj. 200 10/31 10,000

31 400

31 Adj. 200

10/31 Bal. 10,600

Illustration 3-14 Receivable and revenue accounts after accrual adjustment

ACCRUED EXPENSES Expenses incurred but not yet paid or recorded at the statement date are accrued expenses. Interest, rent, taxes, and salaries are typical accrued expenses. Accrued expenses result from the same causes as accrued revenues. In fact, an accrued ex- pense on the books of one company is an accrued revenue to another company. For example, Pioneer’s $200 accrual of revenue is an accrued expense to the client that received the service.

An adjusting entry for accrued expenses serves two purposes: (1) It records the obligations that exist at the balance sheet date, and (2) it recognizes the expenses

Cash Flows no effect

A � L � SE �200

�200 Rev

E T H I C S N O T E

Computer Associates International was accused of

backdating sales—that is, saying that a sale that occurred at the beginning of one quarter occurred at the end of the previous quarter, in order to achieve the previous quarter’s sales targets.

A � L � SE �200 �200

Cash Flows �200

of the current accounting period. Prior to adjustment, both liabilities and expenses are understated. Therefore, as Illustration 3-16 shows, an adjusting entry for accrued expenses increases (debits) an expense account and increases (credits) a liability account.

The Basics of Adjusting Entries 107

Accrued Expenses

Expense Liability

Credit Adjusting Entry (+)

Debit Adjusting Entry (+)

Illustration 3-16 Adjusting entries for accrued expenses

H E L P F U L H I N T Interest is a cost of bor- rowing money that accu- mulates with the passage of time.

2We will consider the computation of interest in more depth in later chapters.

Annual Time in Face Value � Interest � Terms of � Interest

of Note Rate One Year $5,000 � 12% � 1/12 � $50

Illustration 3-17 Formula for computing interest

Illustration 3-18 Interest accounts after adjustment

On the next few pages, we will look in more detail at some specific types of accrued expenses, beginning with accrued interest.

Accrued Interest. Pioneer Advertising Agency Inc. signed a $5,000, 3-month note payable on October 1. The note requires Pioneer to pay interest at an annual rate of 12%.

Three factors determine the amount of interest accumulation: (1) the face value of the note, (2) the interest rate, which is always expressed as an annual rate, and (3) the length of time the note is outstanding. For Pioneer, the total interest due on the note at its due date is $150 ($5,000 face value � 12% interest rate � 3/12 time period). The interest is thus $50 per month. Illustration 3-17 shows the formula for computing interest and its application to Pioneer Advertising Agency Inc. for the month of October.2 Note that the time period is expressed as a fraction of a year.

Interest Expense Interest Payable 10/31 Adj. 50 10/31 Adj. 50

Cash Flows no effect

A � L � SE �50 Exp

�50

Pioneer makes the following accrued expense adjusting entry on October 31.

Oct. 31 Interest Expense 50 Interest Payable 50

(To record interest on notes payable)

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

At October 31, the salaries for the last three days of the month represent an accrued expense and a related liability. The employees receive total salaries of $2,000 for a five-day work week, or $400 per day. Thus, accrued salaries at October 31 are $1,200 ($400 � 3). Pioneer makes the following adjusting entry:

Oct. 31 Salaries Expense 1,200 Salaries Payable 1,200

(To record accrued salaries)

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

108 Chapter 3 Adjusting the Accounts

October

Adjustment period

Start of pay period

Payday Payday

S M Tu W Th F S 1 2 3 4 5 6

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

26 15

November

S M Tu W Th F S 1 2 3

4 5 6 7 8 10 11 13 14 15 16 17 18 19 20 21 22 24 25 26 27 28

23 29 30

12 9

Illustration 3-19 Calendar showing Pioneer’s pay periods

Cash Flows no effect

A � L � SE �1,200 Exp

�1,200

Salaries Expense Salaries Payable

10/26 4,000 10/31 Adj. 1,200

31 Adj. 1,200

10/31 Bal. 5,200

Illustration 3-20 Salary accounts after adjustment

Interest Expense shows the interest charges for the month of October. Interest Payable shows the amount of interest owed at the statement date. (As of October 31, they are the same because October is the first month of the note payable.) Pioneer will not pay the interest until the note comes due at the end

of three months. Companies use the Interest Payable account, instead of crediting (increasing) Notes Payable, in order to disclose the two types of obligations—interest and principal—in the accounts and statements. Without this adjusting entry, liabilities and interest expense are under- stated, and net income and stockholders’ equity are overstated.

Accrued Salaries. Companies pay for some types of expenses after the services have been performed. Examples are employee salaries and com- missions. Pioneer last paid salaries on October 26; the next payday is November 9. As the calendar in Illustration 3-19 shows, three working days remain in October (October 29–31).

After this adjustment, the balance in Salaries Expense of $5,200 (13 days � $400) is the actual salary expense for October. The balance in Salaries Payable of $1,200 is the amount of the liability for salaries Pioneer owes as of October 31. Without the $1,200 adjustment for salaries, Pioneer’s expenses are understated $1,200, and its liabilities are understated $1,200.

E T H I C S N O T E

A report released by Fannie Mae’s board of directors

stated that improper adjusting entries at the mortgage-finance company resulted in delayed recognition of expenses caused by interest-rate changes. The motivation for such accounting apparently was the desire to hit earnings estimates.

The Basics of Adjusting Entries 109

ACCOUNTING FOR ACCRUED EXPENSES

Reason for Accounts Before Adjusting Examples Adjustment Adjustment Entry

Interest, rent, Expenses have been Expenses understated. Dr. Expenses salaries incurred but not yet paid Liabilities understated. Cr. Liabilities

in cash or recorded.

Illustration 3-21 Accounting for accrued expenses

Pioneer Advertising pays salaries every two weeks. The next payday is November 9, when the company will again pay total salaries of $4,000. The pay- ment will consist of $1,200 of salaries payable at October 31 plus $2,800 of salaries expense for November (7 working days as shown in the November calendar � $400). Therefore, Pioneer makes the following entry on November 9.

Nov. 9 Salaries Payable 1,200 Salaries Expense 2,800

Cash 4,000 (To record November 9 payroll)

This entry eliminates the liability for Salaries Payable that Pioneer recorded in the October 31 adjusting entry. It also records the proper amount of Salaries Expense for the period between November 1 and November 9.

Illustration 3-21 summarizes the accounting for accrued expenses.

REVIEW IT 1. If an accrued revenue adjusting entry is not made, what is the effect on

assets, stockholders’ equity, revenues, and net income? 2. If an accrued expense adjusting entry is not made, what is the effect on

liabilities, stockholders’ equity, expenses, and net income?

DO IT Calvin and Hobbs are the new owners of Micro Computer Services Inc. At the end of August 2008, their first month of ownership, Calvin and Hobbs are try- ing to prepare monthly financial statements. They have the following informa- tion for the month. 1. At August 31, Micro Computer owed employees $800 in salaries that will

be paid on September 1. 2. On August 1, Micro Computer borrowed $30,000 from a local bank on a

15-year note. The annual interest rate is 10%. 3. Service revenue unrecorded in August totaled $1,100. Prepare the adjusting entries needed at August 31, 2008.

Action Plan ■ Make adjusting entries at the end of the period for revenues earned and

expenses incurred in the period. ■ Don’t forget to make adjusting entries for accruals. Adjusting entries for

accruals will increase both a balance sheet and an income statement account.

Before You Go On. . .

Cash Flows �4,000

A � L � SE �1,200

�2,800 Exp �4,000

110 Chapter 3 Adjusting the Accounts

GENERAL JOURNAL J2

Date Account Titles and Explanation Ref. Debit Credit

2008 Adjusting Entries

Oct. 31 Advertising Supplies Expense 631 1,500 Advertising Supplies 126 1,500

(To record supplies used)

31 Insurance Expense 722 50 Prepaid Insurance 130 50

(To record insurance expired)

31 Depreciation Expense 711 40 Accumulated Depreciation—Office Equipment 158 40

(To record monthly depreciation)

31 Unearned Revenue 209 400 Service Revenue 400 400

(To record revenue for services provided)

31 Accounts Receivable 112 200 Service Revenue 400 200

(To record revenue for services provided)

31 Interest Expense 905 50 Interest Payable 230 50

(To record interest on notes payable)

31 Salaries Expense 726 1,200 Salaries Payable 212 1,200

(To record accrued salaries)

Illustration 3-22 General journal showing adjusting entries

H E L P F U L H I N T (1) Adjusting entries should not involve debits or credits to cash. (2) Evaluate whether the adjustment makes sense. For example, an adjust- ment to recognize sup- plies used should increase supplies expense. (3) Double-check all computations. (4) Each adjusting entry affects one balance sheet account and one income statement account.

Summary of Journalizing and Posting Illustrations 3-22 and 3-23 show the journalizing and posting of adjusting entries for Pioneer Advertising Agency Inc. on October 31. The ledger identifies all adjust- ments by the reference J2 because they have been recorded on page 2 of the general journal.The company may insert a center caption “Adjusting Entries” between the last transaction entry and the first adjusting entry in the journal. When you review the general ledger in Illustration 3-23, note that the entries highlighted in color are the adjustments.

Solution 1. Salaries Expense 800

Salaries Payable 800 (To record accrued salaries)

2. Interest Expense 250 Interest Payable 250

(To record interest) ($30,000 � 10% � 1/12 = $250)

3. Accounts Receivable 1,100 Service Revenue 1,100

(To record revenue for services provided)

Related exercise material: BE3-7, E3-5, E3-6, E3-7, E3-8, E3-9, E3-10, E3-11, E3-12, and E3-13.

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GENERAL LEDGER

Cash No. 101 Date Explanation Ref. Debit Credit Balance

2008 Oct. 1 J1 10,000 10,000

2 J1 1,200 11,200 3 J1 900 10,300 4 J1 600 9,700

20 J1 500 9,200 26 J1 4,000 5,200 31 J1 10,000 15,200

Accounts Receivable No. 112 Date Explanation Ref. Debit Credit Balance

2008 Oct. 31 Adj. entry J2 200 200

Advertising Supplies No. 126 Date Explanation Ref. Debit Credit Balance

2008 Oct. 5 J1 2,500 2,500

31 Adj. entry J2 1,500 1,000

Prepaid Insurance No. 130 Date Explanation Ref. Debit Credit Balance

2008 Oct. 4 J1 600 600

31 Adj. entry J2 50 550

Office Equipment No. 157 Date Explanation Ref. Debit Credit Balance

2008 Oct. 1 J1 5,000 5,000

Accumulated Depreciation—Office Equipment No. 158 Date Explanation Ref. Debit Credit Balance

2008 Oct. 31 Adj. entry J2 40 40

Notes Payable No. 200 Date Explanation Ref. Debit Credit Balance

2008 Oct. 1 J1 5,000 5,000

Accounts Payable No. 201 Date Explanation Ref. Debit Credit Balance

2008 Oct. 5 J1 2,500 2,500

Unearned Revenue No. 209 Date Explanation Ref. Debit Credit Balance

2008 Oct. 2 J1 1,200 1,200

31 Adj. entry J2 400 800

Salaries Payable No. 212 Date Explanation Ref. Debit Credit Balance

2008 Oct. 31 Adj. entry J2 1,200 1,200

Interest Payable No. 230 Date Explanation Ref. Debit Credit Balance

2008 Oct. 31 Adj. entry J2 50 50

Common Stock No. 311 Date Explanation Ref. Debit Credit Balance

2008 Oct. 1 J1 10,000 10,000

Retained Earnings No. 320 Date Explanation Ref. Debit Credit Balance

2008

Dividends No. 332 Date Explanation Ref. Debit Credit Balance

2008 Oct. 20 J1 500 500

Service Revenue No. 400 Date Explanation Ref. Debit Credit Balance

2008 Oct. 31 J1 10,000 10,000 Oct. 31 Adj. entry J2 400 10,400 cOt. 31 Adj. entry J2 200 10,600

Advertising Supplies Expense No. 631 Date Explanation Ref. Debit Credit Balance

2008 Oct. 31 Adj. entry J2 1,500 1,500

Depreciation Expense No. 711 Date Explanation Ref. Debit Credit Balance

2008 Oct. 31 Adj. entry J2 40 40

Insurance Expense No. 722 Date Explanation Ref. Debit Credit Balance

2008 Oct. 31 Adj. entry J2 50 50

Salaries Expense No. 726 Date Explanation Ref. Debit Credit Balance

2008 Oct. 26 J1 4,000 4,000

31 Adj. entry J2 1,200 5,200

Rent Expense No. 729 Date Explanation Ref. Debit Credit Balance

2008 Oct. 3 J1 900 900

Interest Expense No. 905 Date Explanation Ref. Debit Credit Balance

2008 Oct. 31 Adj. entry J2 50 50

Illustration 3-23 General ledger after adjustment 111

The company has journalized and posted all adjusting entries. Next it prepares another trial balance from the ledger accounts. This is called an adjusted trial balance. Its purpose is to prove the equality of the total debit balances and the total credit balances in the ledger after all adjust-

ments.The accounts in the adjusted trial balance contain all data that the company needs to prepare financial statements.

Preparing the Adjusted Trial Balance Illustration 3-24 presents the adjusted trial balance for Pioneer Advertising Agency Inc., prepared from the ledger accounts in Illustration 3-23. The amounts highlighted in color are those affected by the adjusting entries. Compare these amounts to those in the unadjusted trial balance in Illustration 3-3 on page 98.

112 Chapter 3 Adjusting the Accounts

Illustration 3-24 Adjusted trial balance PIONEER ADVERTISING AGENCY INC.

Adjusted Trial Balance October 31, 2008

Dr. Cr. Cash $15,200 Accounts Receivable 200 Advertising Supplies 1,000 Prepaid Insurance 550 Office Equipment 5,000 Accumulated Depreciation—Office Equipment $ 40 Notes Payable 5,000 Accounts Payable 2,500 Unearned Revenue 800 Salaries Payable 1,200 Interest Payable 50 Common Stock 10,000 Retained Earnings –0– Dividends 500 Service Revenue 10,600 Salaries Expense 5,200 Advertising Supplies Expense 1,500 Rent Expense 900 Insurance Expense 50 Interest Expense 50 Depreciation Expense 40

$30,190 $30,190

THE ADJUSTED TRIAL BALANCE AND FINANCIAL STATEMENTS

Describe the nature and purpose of an adjusted trial balance.

S T U D Y O B J E C T I V E 7

The Adjusted Trial Balance and Financial Statements 113

Preparing Financial Statements Companies can prepare financial statements directly from the adjusted trial bal- ance. Illustrations 3-25 and 3-26 show the interrelationships of data in the adjusted trial balance and the financial statements.

As Illustration 3-25 shows, companies first prepare the income statement from the revenue and expense accounts. Next, they use the Retained Earnings and Dividends accounts and the net income (or net loss) from the income statement to prepare the retained earnings statement. As Illustration 3-26 shows, companies then prepare the balance sheet from the asset and liability accounts, the common stock account, and the ending retained earnings balance as reported in the retained earnings statement.

PIONEER ADVERTISING AGENCY INC. Adjusted Trial Balance

October 31, 2008

Cash Accounts Receivable Advertising Supplies Prepaid Insurance Office Equipment Accumulated Depreciation— Office Equipment Notes Payable Accounts Payable Unearned Revenue Salaries Payable Interest Payable Common Stock

$15,200 200

1,000 550

5,000

500

5,200 1,500

900 50 50 40

$ 40 5,000 2,500

800 1,200

50 10,000

–0–

10,600

$30,190 $30,190

Debit Credit

PIONEER ADVERTISING AGENCY INC. Income Statement

For the Month Ended October 31, 2008

Revenues Service Revenue

Expenses Salaries expense Advertising supplies expense Rent expense Insurance expense Interest expense Depreciation expense

Total expenses

Net income

$5,200 1,500

900 50 50 40

$10,600

7,740

$ 2,860

PIONEER ADVERTISING AGENCY INC. Retained Earnings Statement

For the Month Ended October 31, 2008

Retained earnings, October 1 Add: Net income

–0– 2,860

2,860

Service Revenue Salaries Expense Advertising Supplies Expense Rent Expense Insurance Expense Interest Expense Depreciation Expense

Retained Earnings Dividends

Account

500 $2,360

Less: Dividends Retained earnings, October 31

To balance sheet

Illustration 3-25 Preparation of the income statement and retained earnings statement from the adjusted trial balance

114 Chapter 3 Adjusting the Accounts

PIONEER ADVERTISING AGENCY INC. Adjusted Trial Balance

October 31, 2008

Cash Accounts Receivable Advertising Supplies Prepaid Insurance Office Equipment Accumulated Depreciation— Office Equipment Notes Payable Accounts Payable Unearned Revenue Salaries Payable Interest Payable Common Stock Retained Earnings Dividends Service Revenue Salaries Expense Advertising Supplies Expense Rent Expense Insurance Expense Interest Expense Depreciation Expense

$15,200 200

1,000 550

5,000

500

5,200 1,500

900 50 50 40

$ 40 5,000 2,500

800 1,200

50 10,000

–0–

10,600

$30,190 $30,190

Account Debit Credit

PIONEER ADVERTISING AGENCY INC. Balance Sheet

October 31, 2008

Cash Accounts receivable Advertising supplies Prepaid insurance Office equipment Less: Accumulated depreciation Total assets

$5,000 40

Assets

Liabilities Notes payable Accounts payable Unearned revenue Salaries payable Interest payable Total liabilities Stockholders’ equity Common stock Retained earnings Total liabilities and stockholders’ equity

$15,200 200

1,000 550

4,960 $21,910

Liabilities and Stockholders’ Equity

$ 5,000

2,500 800 1,200

50 9,550

10,000

2,360

$21,910

Balance at Oct. 31 from Retained Earnings Statement in Illustration 3-25

Illustration 3-26 Preparation of the balance sheet from the adjusted trial balance

REVIEW IT 1. What is the purpose of an adjusted trial balance? 2. How do companies prepare an adjusted trial balance?

Before You Go On...

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Be sure to read ALL ABOUT YOU: Is Your Old Computer a Liability? on the next page for information on how topics in this chapter apply to you.*

Some Facts* *California adds $6 to $10 of sales tax to the cost of

computers and televisions to fund recycling programs.

* Each cathode ray tube (CRT) monitor contains 4–6 pounds of lead. Consumer electronic products account for about 40% of the lead found in landfills.

* Environmental groups put a resolution on Apple Computer’s 2006 shareholder meeting agenda requiring the company to study how it can increase recycling.

* The average household has two to three old computers in its garage or storage area.

*all about Y U*

Source for graph: Silicon Valley Toxics Coalition, “Poison PCs and Toxic TVs,” www.svtc.org/cleancc/ pubs/ppcttv2004.pdf, p. 5.

1980 1986 1992 1998 2004 2010 0

50

100

150

M IL

LI O

N S

O F

TO N

S

E-WASTE TSUNAMI

200

250

300 E-waste in Storage

E-waste Recycled

E-waste LandfilledE-waste Landfilled

DDo you have an old computer or two in your garage?How about an old TV that needs replacing? Many people do. Approximately 163,000 computers and televisions become obsolete each day. Yet, in a recent year, only 11% of computers were recycled. It is estimated that 75% of all computers ever sold are sitting in storage somewhere, waiting to be disposed of. Each of these old TVs and computers is loaded with lead, cadmium, mercury, and other toxic chemicals. If you have one these electronic gadgets, you have a responsibility, and a probable cost, for disposing of it.

What about companies? Many have potential pollution or environmental-disposal problems—not only for electronic gadgets, but also for the lead paint or asbestos they sold. How do we fit these issues into the accounting equation? Are these costs and related liabilities that companies should report?

In the past, two arguments were made for excluding pollution and environmental costs from the financial statements of product manufacturers. First, companies argued that pollution wasn’t their responsibility. If it wasn’t their responsibility, then there was no liability. Second, even if there was a liability, companies argued that they could not easily estimate its amount.

These arguments may be as out-of-date as last year’s cell phone model. Increasingly, states are putting environmental liabilities into the accounting equation by passing laws that hold companies responsible for the toxic waste from their discarded products. Also, courts are levying steep fines for environmental cleanup caused by product waste.

What Do You Think?* Should companies accrue for environmental clean-up costs as liabilities on their financial statements?

YES: As more states impose laws holding companies responsible, and as more courts levy pollution-related fines, it becomes increasingly likely that companies will have to pay large amounts in the future.

NO: The amounts still are too difficult to estimate. Putting inaccurate esti- mates on the financial statements reduces their usefulness. Instead, why not charge the costs later, when the actual environmental clean-up or disposal oc- curs, at which time the company knows the actual cost?

* The authors’ comments on this situation appear on page 140.

Sources: Lorraine Woellert, “HP Wants Your Old PCs Back,” Business Week, April 10, 2006, pp. 82-83; “Poison PCs and Toxic TVs: E-waste Tsunami to Roll Across the U.S.: Are We Prepared?” 2004 report of the Silicon Valley Toxics Coalition.

About the Numbers* The nearby chart shows the amount of electronic products, in millions of tons, in storage, now being recycled, and in landfills.

115

Is Your Old Computer a Liability?

116 Chapter 3 Adjusting the Accounts

SUMMARY OF STUDY OBJECTIVES 1 Explain the time period assumption. The time period

assumption assumes that the economic life of a business is divided into artificial time periods.

2 Explain the accrual basis of accounting. Accrual-basis accounting means that companies record events that

change a company’s financial statements in the periods in which those events occur, rather than in the periods in which the company receives or pays cash.

3 Explain the reasons for adjusting entries. Companies make adjusting entries at the end of an accounting period.

Demonstration Problem

Green Thumb Lawn Care Inc. began operating on April 1. At April 30, the trial balance shows the following balances for selected accounts.

Prepaid Insurance $ 3,600 Equipment 28,000 Notes Payable 20,000 Unearned Revenue 4,200 Service Revenue 1,800

Analysis reveals the following additional data.

1. Prepaid insurance is the cost of a 2-year insurance policy, effective April 1. 2. Depreciation on the equipment is $500 per month. 3. The note payable is dated April 1. It is a 6-month, 12% note. 4. Seven customers paid for the company’s 6 months’ lawn service package of $600

beginning in April. The company performed services for these customers in April. 5. Lawn services provided other customers but not recorded at April 30 totaled $1,500.

Instructions Prepare the adjusting entries for the month of April. Show computations.

GENERAL JOURNAL J1

Date Account Titles and Explanation Ref. Debit Credit

Adjusting Entries

Apr. 30 Insurance Expense 150 Prepaid Insurance 150

(To record insurance expired: $3,600 � 24 = $150 per month)

30 Depreciation Expense 500 Accumulated Depreciation—Equipment 500

(To record monthly depreciation)

30 Interest Expense 200 Interest Payable 200

(To record interest on notes payable: $20,000 � 12% � 1/12 = $200)

30 Unearned Revenue 700 Service Revenue 700

(To record service revenue: $600 � 6 = $100; $100 per month � 7 = $700)

30 Accounts Receivable 1,500 Service Revenue 1,500

(To record revenue for services provided)

Solution

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action plan ✔ Note that adjustments are being made for one month. ✔ Make computations carefully. ✔ Select account titles carefully. ✔ Make sure debits are made first and credits are indented. ✔ Check that debits equal credits for each entry.

GLOSSARY

Appendix Alternative Treatment of Prepaid Expenses and Unearned Revenues 117

Accrual-basis accounting Accounting basis in which com- panies record transactions that change a company’s financial statements in the periods in which the events occur. (p. 95).

Accruals Adjusting entries for either accrued revenues or ac- crued expenses. (p. 97).

Accrued expenses Expenses incurred but not yet paid in cash or recorded. (p. 106).

Accrued revenues Revenues earned but not yet received in cash or recorded. (p. 105).

Adjusted trial balance A list of accounts and their balances after the company has made all adjustments. (p. 112).

Adjusting entries Entries made at the end of an accounting period to ensure that companies follow the revenue recog- nition and matching principles. (p. 97).

Book value The difference between the cost of a deprecia- ble asset and its related accumulated depreciation. (p. 102).

Calendar year An accounting period that extends from January 1 to December 31. (p. 95).

Cash-basis accounting Accounting basis in which compa- nies record revenue when they receive cash and an expense when they pay cash. (p. 95).

Contra asset account An account offset against an asset account on the balance sheet. (p. 101).

Deferrals Adjusting entries for either prepaid expenses or unearned revenues. (p. 97).

Depreciation The allocation of the cost of an asset to expense over its useful life in a rational and systematic manner.(p.101).

Fiscal year An accounting period that is one year in length. (p. 95).

Interim periods Monthly or quarterly accounting time peri- ods. (p. 95).

Matching principle The principle that companies match ef- forts (expenses) with accomplishments (revenues). (p. 96).

Prepaid expenses Expenses paid in cash that benefit more than one accounting period and that are recorded as assets. (p. 98).

Revenue recognition principle The principle that compa- nies recognize revenue in the accounting period in which it is earned. (p. 95).

Time period assumption An assumption that accountants can divide the economic life of a business into artificial time periods. (p. 94).

Unearned revenues Cash received and recorded as liabili- ties before revenue is earned. (p. 102).

Useful life The length of service of a productive facility. (p. 101).

APPENDIX Alternative Treatment of Prepaid Expenses and Unearned Revenues In discussing adjusting entries for prepaid expenses and unearned revenues, we illustrated transactions for which companies made the initial entries to balance sheet accounts. In the case of prepaid expenses, the company deb- ited the prepayment to an asset account. In the case of unearned revenue, the company credited a liability account to record the cash received.

Some companies use an alternative treatment: (1) When a company prepays an expense, it debits that amount to an expense account. (2) When it receives payment for future services, it credits the amount to a revenue account. In this appendix, we describe the circumstances that justify such entries and the different adjusting

Prepare adjusting entries for the alternative treatment of deferrals.

S T U D Y O B J E C T I V E 8

Such entries ensure that companies record revenues in the period in which they are earned and that they recognize expenses in the period in which they are incurred.

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

5 Prepare adjusting entries for deferrals. Deferrals are either prepaid expenses or unearned revenues. Companies make adjusting entries for deferrals to record the portion of the prepayment that represents the expense incurred or the revenue earned in the current accounting period.

6 Prepare adjusting entries for accruals. Accruals are ei- ther accrued revenues or accrued expenses. Companies make adjusting entries for accruals to record revenues earned and expenses incurred in the current accounting pe- riod that have not been recognized through daily entries.

7 Describe the nature and purpose of an adjusted trial balance. An adjusted trial balance shows the balances of all accounts, including those that have been adjusted, at the end of an accounting period. Its purpose is to prove the equality of the total debit balances and total credit bal- ances in the ledger after all adjustments.

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entries that may be required. This alternative treatment of prepaid expenses and unearned revenues has the same effect on the financial statements as the proce- dures described in the chapter.

Prepaid Expenses Prepaid expenses become expired costs either through the passage of time (e.g., insurance) or through consumption (e.g., advertising supplies). If, at the time of purchase, the company expects to consume the supplies before the next financial statement date, it may choose to debit (increase) an expense account rather than an asset account. This alternative treatment is simply more convenient.

Assume that Pioneer Advertising Agency Inc. expects that it will use before the end of the month all of the supplies purchased on October 5. A debit of $2,500 to Advertising Supplies Expense (rather than to the asset account Advertising Supplies) on October 5 will eliminate the need for an adjusting entry on October 31. At October 31, the Advertising Supplies Expense account will show a balance of $2,500, which is the cost of supplies used between October 5 and October 31.

But what if the company does not use all the supplies? For example, what if an in- ventory of $1,000 of advertising supplies remains on October 31? Obviously, the com- pany would need to make an adjusting entry.Prior to adjustment, the expense account Advertising Supplies Expense is overstated $1,000, and the asset account Advertising Supplies is understated $1,000.Thus Pioneer makes the following adjusting entry.

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

(To record supplies inventory)

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

118 Chapter 3 Adjusting the Accounts

Advertising Supplies Advertising Supplies Expense

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

10/31 Bal. 1,500

Prepayment Initially Debited to Asset Account

(per chapter)

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

Oct. 31 Advertising Supplies Expense 1,500

Advertising Supplies 1,500

Prepayment Initially Debited to Expense Account

(per appendix)

Oct. 5 Advertising Supplies Expense 2,500

Accounts Payable 2,500

Oct. 31 Advertising Supplies 1,000 Advertising Supplies

Expense 1,000

Illustration 3A-1 Prepaid expenses accounts after adjustment

Illustration 3A-2 Adjustment approaches— a comparison

After adjustment, the asset account Advertising Supplies shows a balance of $1,000, which is equal to the cost of supplies on hand at October 31. In addition, Advertising Supplies Expense shows a balance of $1,500. This is equal to the cost of supplies used between October 5 and October 31. Without the adjusting entry expenses are overstated and net income is understated by $1,000 in the October in- come statement.Also, both assets and stockholders’ equity are understated by $1,000 on the October 31 balance sheet.

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

Cash Flows no effect

A � L � SE �1,000

�1,000 Exp

Note that the account balances under each alternative are the same at October 31: Advertising Supplies $1,000, and Advertising Supplies Expense $1,500.

Unearned Revenues Unearned revenues become earned either through the passage of time (e.g., un- earned rent) or through providing the service (e.g., unearned fees). Similar to the case for prepaid expenses, companies may credit (increase) a revenue account when they receive cash for future services.

To illustrate, assume that Pioneer Advertising Agency Inc. received $1,200 for future services on October 2. Pioneer expects to perform the services before October 31.3 In such a case, the company credits Service Revenue. If it in fact earns the revenue before October 31, no adjustment is needed.

However, if at the statement date Pioneer has not performed $800 of the serv- ices, it would make an adjusting entry. Without the entry, the revenue account Service Revenue is overstated $800, and the liability account Unearned Revenue is understated $800. Thus, Pioneer makes the following adjusting entry.

Oct. 31 Service Revenue 800 Unearned Revenue 800

(To record unearned revenue)

After Pioneer posts the adjusting entry, the accounts show:

Appendix Alternative Treatment of Prepaid Expenses and Unearned Revenues 119

(per chapter) (per appendix) Advertising Supplies Advertising Supplies

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

10/31 Bal. 1,000

Advertising Supplies Expense Advertising Supplies Expense 10/31 Adj. 1,500 10/5 2,500 10/31 Adj. 1,000

10/31 Bal. 1,500

Illustration 3A-3 Comparison of accounts

H E L P F U L H I N T The required adjusted balances here are Service Revenue $400 and Unearned Revenue $800.

Unearned Revenue Service Revenue

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

10/31 Bal. 400

The liability account Unearned Revenue shows a balance of $800. This equals the services that will be provided in the future. In addition, the balance in Service Revenue equals the services provided in October.Without the adjusting entry, both revenues and net income are overstated by $800 in the October income statement. Also, liabilities are understated by $800, and stockholders’ equity is overstated by $800 on the October 31 balance sheet.

Illustration 3A-5 compares the entries and accounts for service revenue earned and unearned in the two adjustment approaches.

3This example focuses only on the alternative treatment of unearned revenues. In the interest of simplicity, we have ignored the entries to Service Revenue pertaining to the immediate earning of revenue ($10,000) and the adjusting entry for accrued revenue ($200).

Illustration 3A-4 Unearned revenue accounts after adjustment

Cash Flows no effect

A � L � SE �800 Rev

�800

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

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

120 Chapter 3 Adjusting the Accounts

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

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

10/31 Bal. 800

Service Revenue Service Revenue

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

10/31 Bal. 400

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

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

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

2. Unearned revenues (a) Unearned revenues initially recorded Liabilities overstated Dr. Liabilities in liability accounts have been earned. Revenues understated Cr. Revenues

(b) Unearned revenues initially recorded Liabilities understated Dr. Revenues in revenue accounts have not been Revenues overstated Cr. Liabilities earned.

Note that the balances in the accounts are the same under the two alternatives: Unearned Revenue $800, and Service Revenue $400.

Summary of Additional Adjustment Relationships Illustration 3A-7 provides a summary of basic relationships for deferrals.

Illustration 3A-6 Comparison of accounts

Illustration 3A-7 Summary of basic relation- ships for deferrals

SUMMARY OF STUDY OBJECTIVE FOR APPENDIX 8 Prepare adjusting entries for the alternative treat-

ment of deferrals. Companies may initially debit prepay- ments to an expense account. Likewise, they may credit un- earned revenues to a revenue account. At the end of the period, these accounts may be overstated. The adjusting

entries for prepaid expenses are a debit to an asset account and a credit to an expense account. Adjusting entries for unearned revenues are a debit to a revenue account and a credit to a liability account.

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

Unearned Revenue Initially Credited

to Liability Account (per chapter)

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

Oct. 31 Unearned Revenue 400 Service Revenue 400

Unearned Revenue Initially Credited to Revenue Account

(per appendix)

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

Oct. 31 Service Revenue 800 Unearned Revenue 800

Illustration 3A-5 Adjustment approaches—a comparison

SELF-STUDY QUESTIONS

Questions 121

*Note: All asterisked Questions, Exercises, and Problems relate to material in the appendix to the chapter.

Answers are at the end of the chapter.

1. The time period assumption states that: a. revenue should be recognized in the accounting period

in which it is earned. b. expenses should be matched with revenues. c. the economic life of a business can be divided into arti-

ficial time periods. d. the fiscal year should correspond with the calendar year.

2. The principle or assumption dictating that efforts (expenses) be matched with accomplishments (revenues) is the: a. matching principle. b. cost assumption. c. periodicity principle. d. revenue recognition principle.

3. One of the following statements about the accrual basis of accounting is false. That statement is: a. Events that change a company’s financial statements

are recorded in the periods in which the events occur. b. Revenue is recognized in the period in which it is

earned. c. This basis is in accord with generally accepted account-

ing principles. d. Revenue is recorded only when cash is received, and

expense is recorded only when cash is paid. 4. Adjusting entries are made to ensure that:

a. expenses are recognized in the period in which they are incurred.

b. revenues are recorded in the period in which they are earned.

c. balance sheet and income statement accounts have correct balances at the end of an accounting period.

d. all of the above. 5. Each of the following is a major type (or category) of

adjusting entries except: a. prepaid expenses. b. accrued revenues. c. accrued expenses. d. earned revenues.

6. The trial balance shows Supplies $1,350 and Supplies Expense $0. If $600 of supplies are on hand at the end of the period, the adjusting entry is: a. Supplies 600

Supplies Expense 600 b. Supplies 750

Supplies Expense 750

c. Supplies Expense 750 Supplies 750

d. Supplies Expense 600 Supplies 600

7. Adjustments for unearned revenues: a. decrease liabilities and increase revenues. b. have an assets and revenues account relationship. c. increase assets and increase revenues. d. decrease revenues and decrease assets.

8. Adjustments for accrued revenues: a. have a liabilities and revenues account relationship. b. have an assets and revenues account relationship. c. decrease assets and revenues. d. decrease liabilities and increase revenues.

9. Kathy Siska earned a salary of $400 for the last week of September. She will be paid on October 1. The adjusting entry for Kathy’s employer at September 30 is: a. No entry is required. b. Salaries Expense 400

Salaries Payable 400 c. Salaries Expense 400

Cash 400 d. Salaries Payable 400

Cash 400 10. Which of the following statements is incorrect concerning

the adjusted trial balance? a. An adjusted trial balance proves the equality of the

total debit balances and the total credit balances in the ledger after all adjustments are made.

b. The adjusted trial balance provides the primary basis for the preparation of financial statements.

c. The adjusted trial balance lists the account balances segregated by assets and liabilities.

d. The adjusted trial balance is prepared after the adjust- ing entries have been journalized and posted.

*11. The trial balance shows Supplies $0 and Supplies Expense $1,500. If $800 of supplies are on hand at the end of the period, the adjusting entry is: a. Debit Supplies $800 and credit Supplies Expense $800. b. Debit Supplies Expense $800 and credit Supplies $800. c. Debit Supplies $700 and credit Supplies Expense $700. d. Debit Supplies Expense $700 and credit Supplies $700.

Go to the book’s website, www.wiley.com/college/weygandt, for Additional Self-Study questions.

(SO 1)

(SO 5)

(SO 6)

(SO 6)

(SO 7)

(SO 8)

(SO 2)

(SO 2)

(SO 3)

(SO 4)

(SO 5)

QUESTIONS 1. (a) How does the time period assumption affect an

accountant’s analysis of business transactions? (b) Explain the terms fiscal year, calendar year, and

interim periods.

2. State two generally accepted accounting principles that relate to adjusting the accounts.

3. Rick Marsh, a lawyer, accepts a legal engagement in March, performs the work in April, and is paid in May. If Marsh’s

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law firm prepares monthly financial statements, when should it recognize revenue from this engagement? Why?

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

5. In completing the engagement in question 3, Marsh pays no costs in March, $2,000 in April, and $2,500 in May (in- curred in April). How much expense should the firm deduct from revenues in the month when it recognizes the revenue? Why?

6. “Adjusting entries are required by the cost principle of accounting.” Do you agree? Explain.

7. Why may a trial balance not contain up-to-date and com- plete financial information?

8. Distinguish between the two categories of adjusting entries, and identify the types of adjustments applicable to each category.

9. What is the debit/credit effect of a prepaid expense ad- justing entry?

10. “Depreciation is a valuation process that results in the reporting of the fair market value of the asset.” Do you agree? Explain.

11. Explain the differences between depreciation expense and accumulated depreciation.

12. Shinn Company purchased equipment for $18,000. By the current balance sheet date, $6,000 had been depreciated. Indicate the balance sheet presentation of the data.

13. What is the debit/credit effect of an unearned revenue adjusting entry?

14. A company fails to recognize revenue earned but not yet received. Which of the following accounts are involved in the adjusting entry: (a) asset, (b) liability, (c) revenue, or (d) expense? For the accounts selected, indicate whether they would be debited or credited in the entry.

15. A company fails to recognize an expense incurred but not paid. Indicate which of the following accounts is debited and which is credited in the adjusting entry: (a) asset, (b) liability, (c) revenue, or (d) expense.

122 Chapter 3 Adjusting the Accounts

16. A company makes an accrued revenue adjusting entry for $900 and an accrued expense adjusting entry for $700. How much was net income understated prior to these en- tries? Explain.

17. On January 9, a company pays $5,000 for salaries, of which $2,000 was reported as Salaries Payable on December 31. Give the entry to record the payment.

18. For each of the following items before adjustment, indi- cate the type of adjusting entry (prepaid expense, unearned revenue, accrued revenue, and accrued expense) that is needed to correct the misstatement. If an item could result in more than one type of adjusting entry, indi- cate each of the types. (a) Assets are understated. (b) Liabilities are overstated. (c) Liabilities are understated. (d) Expenses are understated. (e) Assets are overstated. (f) Revenue is understated.

19. One-half of the adjusting entry is given below. Indicate the account title for the other half of the entry. (a) Salaries Expense is debited. (b) Depreciation Expense is debited. (c) Interest Payable is credited. (d) Supplies is credited. (e) Accounts Receivable is debited. (f) Unearned Service Revenue is debited.

20. “An adjusting entry may affect more than one balance sheet or income statement account.” Do you agree? Why or why not?

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

*22. Adel Company debits Supplies Expense for all purchases of supplies and credits Rent Revenue for all advanced rentals. For each type of adjustment, give the adjusting entry.

BRIEF EXERCISES BE3-1 The ledger of Dey Company includes the following accounts. Explain why each account may require adjustment.

(a) Prepaid Insurance (c) Unearned Revenue (b) Depreciation Expense (d) Interest Payable

BE3-2 Nunez Company accumulates the following adjustment data at December 31. Indicate (a) the type of adjustment (prepaid expense, accrued revenues and so on), and (b) the status of accounts before adjustment (overstated or understated).

1. Supplies of $100 are on hand. 2. Services provided but not recorded total $900. 3. Interest of $200 has accumulated on a note payable. 4. Rent collected in advance totaling $800 has been earned.

BE3-3 Windsor Advertising Company’s trial balance at December 31 shows Advertising Supplies $6,700 and Advertising Supplies Expense $0. On December 31, there are $2,700 of sup- plies on hand. Prepare the adjusting entry at December 31, and using T accounts, enter the bal- ances in the accounts, post the adjusting entry, and indicate the adjusted balance in each account.

Indicate why adjusting entries are needed.

(SO 3)

Identify the major types of adjusting entries.

(SO 4)

Prepare adjusting entry for supplies.

(SO 5)

BE3-4 At the end of its first year, the trial balance of Denton Company shows Equipment $30,000 and zero balances in Accumulated Depreciation—Equipment and Depreciation Expense. Depreciation for the year is estimated to be $5,000. Prepare the adjusting entry for depreciation at December 31, post the adjustments to T accounts, and indicate the balance sheet presentation of the equipment at December 31.

BE3-5 On July 1, 2008, Spahn Co. pays $18,000 to Randle Insurance Co. for a 3-year insurance contract. Both companies have fiscal years ending December 31. For Spahn Co., journalize and post the entry on July 1 and the adjusting entry on December 31.

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

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

1. Interest on notes payable of $400 is accrued. 2. Services provided but not recorded total $1,500. 3. Salaries earned by employees of $900 have not been recorded.

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

BE3-8 The trial balance of Bair Company includes the following balance sheet accounts. Identify the accounts that may require adjustment. For each account that requires adjustment, indicate (a) the type of adjusting entry (prepaid expenses, unearned revenues, accrued revenues, and accrued expenses) and (b) the related account in the adjusting entry.

Accounts Receivable Interest Payable Prepaid Insurance Unearned Service Revenue Accumulated Depreciation—Equipment

BE3-9 The adjusted trial balance of Harmony Company, Inc. at December 31, 2008, includes the following accounts: Common Stock $15,600; Dividends $6,000; Service Revenue $35,400; Salaries Expense $16,000; Insurance Expense $2,000; Rent Expense $4,000; Supplies Expense $1,500; and Depreciation Expense $1,300. Prepare an income statement for the year.

BE3-10 Partial adjusted trial balance data for Harmony Company, Inc. is presented in BE3-9.The balance in Common Stock is the balance as of January 1. Prepare a retained earnings statement for the year assuming net income is $10,600 for the year and retained earnings is $0 on January 1.

*BE3-11 Duncan Company records all prepayments in income statement accounts.At April 30, the trial balance shows Supplies Expense $2,800, Service Revenue $9,200, and zero balances in related balance sheet accounts. Prepare the adjusting entries at April 30 assuming (a) $1,000 of supplies on hand and (b) $3,000 of service revenue should be reported as unearned.

Exercises 123

Prepare adjusting entry for depreciation.

(SO 5)

Prepare adjusting entry for prepaid expense.

(SO 5)

Prepare adjusting entry for unearned revenue.

(SO 5)

Prepare adjusting entries for accruals.

(SO 6)

Analyze accounts in an unadjusted trial balance.

(SO 4)

Prepare an income statement from an adjusted trial balance.

(SO 7)

Prepare a retained earnings statement from an adjusted trial balance.

(SO 7)

Prepare adjusting entries under alternative treatment of deferrals.

(SO 8)

Explain the time period assumption.

(SO 1)

Distinguish between cash and accrual basis of accounting.

(SO 2)

EXERCISES E3-1 Jo Seacat has prepared the following list of statements about the time period assumption.

1. Adjusting entries would not be necessary if a company’s life were not divided into artificial time periods.

2. The IRS requires companies to file annual tax returns. 3. Accountants divide the economic life of a business into artificial time periods, but each trans-

action affects only one of these periods. 4. Accounting time periods are generally a month, a quarter, or a year. 5. A time period lasting one year is called an interim period. 6. All fiscal years are calendar years, but not all calendar years are fiscal years.

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

E3-2 On numerous occasions, proposals have surfaced to put the federal government on the ac- crual basis of accounting.This is no small issue. If this basis were used, it would mean that billions in unrecorded liabilities would have to be booked, and the federal deficit would increase substantially.

Instructions (a) What is the difference between accrual-basis accounting and cash-basis accounting? (b) Why would politicians prefer the cash basis over the accrual basis? (c) Write a letter to your senator explaining why the federal government should adopt the

accrual basis of accounting.

E3-3 Conan Industries collected $100,000 from customers in 2008. Of the amount collected, $25,000 was from revenue earned on account in 2007. In addition, Conan earned $40,000 of rev- enue in 2008, which will not be collected until 2009.

Conan Industries also paid $70,000 for expenses in 2008. Of the amount paid, $30,000 was for expenses incurred on account in 2007. In addition, Conan incurred $42,000 of expenses in 2008, which will not be paid until 2009.

Instructions (a) Compute 2008 cash-basis net income. (b) Compute 2008 accrual-basis net income.

E3-4 Emeril Corporation encounters the following situations:

1. Emeril collects $1,000 from a customer in 2008 for services to be performed in 2009. 2. Emeril incurs utility expense which is not yet paid in cash or recorded. 3. Emeril’s employees worked 3 days in 2008, but will not be paid until 2009. 4. Emeril earned service revenue but has not yet received cash or recorded the transaction. 5. Emeril paid $2,000 rent on December 1 for the 4 months starting December 1. 6. Emeril received cash for future services and recorded a liability until the revenue was

earned. 7. Emeril performed consulting services for a client in December 2008. On December 31, it

billed the client $1,200. 8. Emeril paid cash for an expense and recorded an asset until the item was used up. 9. Emeril purchased $900 of supplies in 2008; at year-end, $400 of supplies remain unused.

10. Emeril purchased equipment on January 1, 2008; the equipment will be used for 5 years. 11. Emeril borrowed $10,000 on October 1, 2008, signing an 8% one-year note payable.

Instructions Identify what type of adjusting entry (prepaid expense, unearned revenue, accrued expense, ac- crued revenue) is needed in each situation, at December 31, 2008.

E3-5 Drew Carey Company has the following balances in selected accounts on December 31, 2008.

Accounts Receivable $ -0- Accumulated Depreciation—Equipment -0- Equipment 7,000 Interest Payable -0- Notes Payable 10,000 Prepaid Insurance 2,100 Salaries Payable -0- Supplies 2,450 Unearned Consulting Revenue 40,000

All the accounts have normal balances. The information below has been gathered at December 31, 2008.

1. Drew Carey Company borrowed $10,000 by signing a 12%, one-year note on September 1, 2008.

2. A count of supplies on December 31, 2008, indicates that supplies of $800 are on hand. 3. Depreciation on the equipment for 2008 is $1,000. 4. Drew Carey Company paid $2,100 for 12 months of insurance coverage on June 1, 2008. 5. On December 1, 2008, Drew Carey collected $40,000 for consulting services to be performed

from December 1, 2008, through March 31, 2009. 6. Drew Carey performed consulting services for a client in December 2008. The client will be

billed $4,200. 7. Drew Carey Company pays its employees total salaries of $9,000 every Monday for the pre-

ceding 5-day week (Monday through Friday). On Monday, December 29, employees were paid for the week ending December 26. All employees worked the last 3 days of 2008.

124 Chapter 3 Adjusting the Accounts

Compute cash and accrual accounting income.

(SO 2)

Identify the type of adjusting entry needed.

(SO 4)

Prepare adjusting entries from selected data.

(SO 5, 6)

Instructions Prepare adjusting entries for the seven items described on page 124.

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

1. Services provided but not recorded total $750. 2. Store supplies of $300 have been used. 3. Utility expenses of $225 are unpaid. 4. Unearned revenue of $260 has been earned. 5. Salaries of $900 are unpaid. 6. Prepaid insurance totaling $350 has expired.

Instructions For each of the above items indicate the following.

(a) The type of adjustment (prepaid expense, unearned revenue, accrued revenue, or accrued expense).

(b) The status of accounts before adjustment (overstatement or understatement).

E3-7 The ledger of Piper Rental Agency on March 31 of the current year includes the follow- ing selected accounts before adjusting entries have been prepared.

Debit Credit Prepaid Insurance $ 3,600 Supplies 2,800 Equipment 25,000 Accumulated

Depreciation—Equipment $ 8,400 Notes Payable 20,000 Unearned Rent 9,900 Rent Revenue 60,000 Interest Expense –0– Wages Expense 14,000

An analysis of the accounts shows the following.

1. The equipment depreciates $400 per month. 2. One-third of the unearned rent was earned during the quarter. 3. Interest of $500 is accrued on the notes payable. 4. Supplies on hand total $700. 5. Insurance expires at the rate of $200 per month.

Instructions Prepare the adjusting entries at March 31, assuming that adjusting entries are made quarterly. Additional accounts are: Depreciation Expense, Insurance Expense, Interest Payable, and Supplies Expense.

E3-8 Andy Wright, D.D.S., opened a dental practice on January 1, 2008. During the first month of operations the following transactions occurred.

1. Performed services for patients who had dental plan insurance. At January 31, $875 of such services was earned but not yet recorded.

2. Utility expenses incurred but not paid prior to January 31 totaled $520. 3. Purchased dental equipment on January 1 for $80,000, paying $20,000 in cash and signing a

$60,000, 3-year note payable. The equipment depreciates $400 per month. Interest is $500 per month.

4. Purchased a one-year malpractice insurance policy on January 1 for $12,000. 5. Purchased $1,600 of dental supplies. On January 31, determined that $400 of supplies were on

hand.

Instructions Prepare the adjusting entries on January 31. Account titles are: Accumulated Depreciation— Dental Equipment, Depreciation Expense, Service Revenue, Accounts Receivable, Insurance Expense, Interest Expense, Interest Payable, Prepaid Insurance, Supplies, Supplies Expense, Utilities Expense, and Utilities Payable.

Exercises 125

Identify types of adjustments and account relationships.

(SO 4, 5, 6)

Prepare adjusting entries from selected account data.

(SO 5, 6)

Prepare adjusting entries.

(SO 5, 6)

E3-9 The trial balance for Pioneer Advertising Agency is shown in Illustration 3-3, p. 98. In lieu of the adjusting entries shown in the text at October 31, assume the following adjustment data.

1. Advertising supplies on hand at October 31 total $500. 2. Expired insurance for the month is $100. 3. Depreciation for the month is $50. 4. Unearned revenue earned in October totals $600. 5. Services provided but not recorded at October 31 are $300. 6. Interest accrued at October 31 is $70. 7. Accrued salaries at October 31 are $1,500.

Instructions Prepare the adjusting entries for the items above.

E3-10 The income statement of Benning Co. for the month of July shows net income of $1,400 based on Service Revenue $5,500, Wages Expense $2,300, Supplies Expense $1,200, and Utilities Expense $600. In reviewing the statement, you discover the following.

1. Insurance expired during July of $400 was omitted. 2. Supplies expense includes $200 of supplies that are still on hand at July 31. 3. Depreciation on equipment of $150 was omitted. 4. Accrued but unpaid wages at July 31 of $300 were not included. 5. Services provided but unrecorded totaled $500.

Instructions Prepare a correct income statement for July 2008.

E3-11 A partial adjusted trial balance of Sila Company at January 31, 2008, shows the following.

SILA COMPANY Adjusted Trial Balance

January 31, 2008

Debit Credit Supplies $ 850 Prepaid Insurance 2,400 Salaries Payable $ 800 Unearned Revenue 750 Supplies Expense 950 Insurance Expense 400 Salaries Expense 1,800 Service Revenue 2,000

Instructions Answer the following questions, assuming the year begins January 1.

(a) If the amount in Supplies Expense is the January 31 adjusting entry, and $500 of supplies was purchased in January, what was the balance in Supplies on January 1?

(b) If the amount in Insurance Expense is the January 31 adjusting entry, and the original insurance premium was for one year, what was the total premium and when was the policy purchased?

(c) If $3,500 of salaries was paid in January, what was the balance in Salaries Payable at December 31, 2007?

(d) If $1,600 was received in January for services performed in January, what was the balance in Unearned Revenue at December 31, 2007?

E3-12 Selected accounts of Tabor Company are shown below and on page 127.

Supplies Expense 7/31 800

Supplies Salaries Payable 7/1 Bal. 1,100 7/31 800 7/31 1,200 7/10 400

126 Chapter 3 Adjusting the Accounts

Prepare adjusting entries.

(SO 5, 6)

Prepare correct income statement.

(SO 5, 6)

Analyze adjusted data.

(SO 4, 5, 6, 7)

Journalize basic transactions and adjusting entries.

(SO 5, 6)

Accounts Receivable Unearned Revenue 7/31 500 7/31 900 7/1 Bal. 1,500

7/20 1,000

Salaries Expense Service Revenue 7/15 1,200 7/14 2,000 7/31 1,200 7/31 900

7/31 500

Instructions After analyzing the accounts, journalize (a) the July transactions and (b) the adjusting entries that were made on July 31. (Hint: July transactions were for cash.)

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

GARCIA COMPANY Trial Balance

August 31, 2008

Before After Adjustment Adjustment

Dr. Cr. Dr. Cr. Cash $10,400 $10,400 Accounts Receivable 8,800 9,800 Office Supplies 2,300 700 Prepaid Insurance 4,000 2,500 Office Equipment 14,000 14,000 Accumulated Depreciation—Office Equipment $ 3,600 $ 4,500 Accounts Payable 5,800 5,800 Salaries Payable –0– 1,100 Unearned Rent 1,500 600 Common Stock 10,000 10,000 Retained Earnings 5,600 5,600 Service Revenue 34,000 35,000 Rent Revenue 11,000 11,900 Salaries Expense 17,000 18,100 Office Supplies Expense –0– 1,600 Rent Expense 15,000 15,000 Insurance Expense –0– 1,500 Depreciation Expense –0– 900

$71,500 $71,500 $74,500 $74,500

Instructions Prepare the adjusting entries that were made.

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

Instructions Prepare the income statement and a retained earnings statement for the year and the balance sheet at August 31.

E3-15 The following data are taken from the comparative balance sheets of Girard Billiards Club, which prepares its financial statements using the accrual basis of accounting.

December 31 2008 2007 Fees receivable from members $14,000 $ 9,000 Unearned fees revenue 17,000 25,000

Fees are billed to members based upon their use of the club’s facilities. Unearned fees arise from the sale of gift certificates, which members can apply to their future use of club facilities.

Exercises 127

Prepare adjusting entries from analysis of trial balances.

(SO 5, 6, 7)

Prepare financial statements from adjusted trial balance.

(SO 7)

Record transactions on accrual basis; convert revenue to cash receipts.

(SO 5, 6)

The 2008 income statement for the club showed that fees revenue of $153,000 was earned during the year.

Instructions (Hint: You will probably find it helpful to use T accounts to analyze these data.)

(a) Prepare journal entries for each of the following events that took place during 2008. (1) Fees receivable from 2007 were all collected. (2) Gift certificates outstanding at the end of 2007 were all redeemed. (3) An additional $35,000 worth of gift certificates were sold during 2008.A portion of these

was used by the recipients during the year; the remainder was still outstanding at the end of 2008.

(4) Fees for 2008 for services provided to members were billed to members. (5) Fees receivable for 2008 (i.e., those billed in item [4] above) were partially collected.

(b) Determine the amount of cash received by the club, with respect to fees, during 2008.

*E3-16 Colin Mochrie Company has the following balances in selected accounts on December 31, 2008.

Consulting Revenue $40,000 Insurance Expense 2,100 Supplies Expense 2,450

All the accounts have normal balances. Colin Mochrie Company debits prepayments to expense accounts when paid, and credits unearned revenues to revenue accounts when received. The fol- lowing information below has been gathered at December 31, 2008.

1. Colin Mochrie Company paid $2,100 for 12 months of insurance coverage on June 1, 2008. 2. On December 1, 2008, Colin Mochrie Company collected $40,000 for consulting services to

be performed from December 1, 2008, through March 31, 2009. 3. A count of supplies on December 31, 2008, indicates that supplies of $800 are on hand.

Instructions Prepare the adjusting entries needed at December 31, 2008.

*E3-17 At Natasha Company, prepayments are debited to expense when paid, and unearned revenues are credited to revenue when received. During January of the current year, the follow- ing transactions occurred.

Jan. 2 Paid $1,800 for fire insurance protection for the year. 10 Paid $1,700 for supplies. 15 Received $6,100 for services to be performed in the future.

On January 31, it is determined that $2,500 of the services fees have been earned and that there are $800 of supplies on hand.

Instructions (a) Journalize and post the January transactions. (Use T accounts.) (b) Journalize and post the adjusting entries at January 31. (c) Determine the ending balance in each of the accounts.

128 Chapter 3 Adjusting the Accounts

Journalize transactions and adjusting entries.

(SO 8)

Journalize adjusting entries.

(SO 8)

EXERCISES: SET B Visit the book’s website at www.wiley.com/college/weygandt, and choose the Student Companion site, to access Exercise Set B.

PROBLEMS: SET A P3-1A Tony Masasi started his own consulting firm, Masasi Company, Inc., on June 1, 2008. The trial balance at June 30 is shown on page 129.

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

(SO 5, 6, 7)

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MASASI COMPANY, INC. Trial Balance

June 30, 2008 Account Number Debit Credit

101 Cash $ 7,150 112 Accounts Receivable 6,000 126 Supplies 2,000 130 Prepaid Insurance 3,000 157 Office Equipment 15,000 201 Accounts Payable $ 4,500 209 Unearned Service Revenue 4,000 311 Common Stock 21,750 400 Service Revenue 7,900 726 Salaries Expense 4,000 729 Rent Expense 1,000

$38,150 $38,150

In addition to those accounts listed on the trial balance, the chart of accounts for Masasi Company, Inc.also contains the following accounts and account numbers:No.158 Accumulated Depreciation— Office Equipment, No. 212 Salaries Payable, No. 244 Utilities Payable, No. 631 Supplies Expense, No. 711 Depreciation Expense, No. 722 Insurance Expense, and No. 732 Utilities Expense.

Other data:

1. Supplies on hand at June 30 are $600. 2. A utility bill for $150 has not been recorded and will not be paid until next month. 3. The insurance policy is for a year. 4. $2,500 of unearned service revenue has been earned at the end of the month. 5. Salaries of $2,000 are accrued at June 30. 6. The office equipment has a 5-year life with no salvage value. It is being depreciated at $250

per month for 60 months. 7. Invoices representing $1,000 of services performed during the month have not been recorded

as of June 30.

Instructions (a) Prepare the adjusting entries for the month of June. Use J3 as the page number for your journal. (b) Post the adjusting entries to the ledger accounts. Enter the totals from the trial balance as be-

ginning account balances and place a check mark in the posting reference column. (c) Prepare an adjusted trial balance at June 30, 2008.

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

NEOSHO RIVER RESORT, INC. Trial Balance

August 31, 2008 Account Number Debit Credit

101 Cash $ 19,600 126 Supplies 3,300 130 Prepaid Insurance 6,000 140 Land 25,000 143 Cottages 125,000 149 Furniture 26,000 201 Accounts Payable $ 6,500 208 Unearned Rent 7,400 275 Mortgage Payable 80,000 311 Common Stock 100,000 332 Dividends 5,000 429 Rent Revenue 80,000 622 Repair Expense 3,600 726 Salaries Expense 51,000 732 Utilities Expense 9,400

$273,900 $273,900

Problems: Set A 129

(c) Adj. trial balance $41,550

Prepare adjusting entries, post, and prepare adjusted trial bal- ance, and financial statements.

(SO 5, 6, 7)

In addition to those accounts listed on the trial balance, the chart of accounts for Neosho River Resort also contains the following accounts and account numbers: No. 112 Accounts Receivable, No. 144 Accumulated Depreciation—Cottages, No. 150 Accumulated Depreciation—Furniture, No.212 Salaries Payable,No.230 Interest Payable,No.320 Retained Earnings,No.620 Depreciation Expense—Cottages, No. 621 Depreciation Expense—Furniture, No. 631 Supplies Expense, No. 718 Interest Expense, and No. 722 Insurance Expense.

Other data:

1. Insurance expires at the rate of $400 per month. 2. A count on August 31 shows $600 of supplies on hand. 3. Annual depreciation is $6,000 on cottages and $2,400 on furniture. 4. Unearned rent of $4,100 was earned prior to August 31. 5. Salaries of $400 were unpaid at August 31. 6. Rentals of $1,000 were due from tenants at August 31. (Use Accounts Receivable.) 7. The mortgage interest rate is 9% per year. (The mortgage was taken out on August 1.)

Instructions (a) Journalize the adjusting entries on August 31 for the 3-month period June 1–August 31. (b) Prepare a ledger using the three-column form of account. Enter the trial balance amounts

and post the adjusting entries. (Use J1 as the posting reference.) (c) Prepare an adjusted trial balance on August 31. (d) Prepare an income statement and a retained earnings statement for the 3 months ending

August 31 and a balance sheet as of August 31.

P3-3A Fernetti Advertising Agency, Inc. was founded by John Fernetti in January of 2007. Presented below are both the adjusted and unadjusted trial balances as of December 31, 2008.

FERNETTI ADVERTISING AGENCY, INC. Trial Balance

December 31, 2008

Unadjusted Adjusted Dr. Cr. Dr. Cr.

Cash $ 11,000 $ 11,000 Accounts Receivable 20,000 22,500 Art Supplies 8,600 5,000 Prepaid Insurance 3,350 2,500 Printing Equipment 60,000 60,000 Accumulated Depreciation $ 28,000 $ 34,000 Accounts Payable 5,000 5,000 Interest Payable –0– 150 Notes Payable 5,000 5,000 Unearned Advertising Fees 7,200 5,600 Salaries Payable –0– 1,300 Common Stock 25,000 25,000 Retained Earnings 500 500 Dividends 12,000 12,000 Advertising Revenue 58,600 62,700 Salaries Expense 10,000 11,300 Insurance Expense 850 Interest Expense 350 500 Depreciation Expense 6,000 Art Supplies Expense 3,600 Rent Expense 4,000 4,000

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

130 Chapter 3 Adjusting the Accounts

(c) Adj. trial balance $278,000 (d) Net income $14,100

Ending retained earnings $9,100 Total assets $199,900

Prepare adjusting entries and financial statements.

(SO 5, 6, 7)

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

December 31, 2008, and a balance sheet at December 31. (c) Answer the following questions.

(1) If the note has been outstanding 6 months, what is the annual interest rate on that note? (2) If the company paid $12,500 in salaries in 2008, what was the balance in Salaries Payable

on December 31, 2007?

P3-4A A review of the ledger of Remington Company at December 31, 2008, produces the following data pertaining to the preparation of annual adjusting entries.

1. Salaries Payable $0.There are eight salaried employees. Salaries are paid every Friday for the current week. Five employees receive a salary of $800 each per week, and three employees earn $600 each per week. December 31 is a Tuesday. Employees do not work weekends. All employees worked the last 2 days of December.

2. Unearned Rent $324,000. The company began subleasing office space in its new building on November 1. At December 31, the company had the following rental contracts that are paid in full for the entire term of the lease.

Term Number of Date (in months) Monthly Rent Leases Nov. 1 6 $4,000 5 Dec. 1 6 8,500 4

3. Prepaid Advertising $15,000. This balance consists of payments on two advertising contracts. The contracts provide for monthly advertising in two trade magazines. The terms of the con- tracts are as follows.

Number of Magazine

Contract Date Amount Issues A650 May 1 $5,400 12 B974 Oct. 1 9,600 24

The first advertisement runs in the month in which the contract is signed.

4. Notes Payable $120,000.This balance consists of a note for one year at an annual interest rate of 9%, dated June 1.

Instructions Prepare the adjusting entries at December 31, 2008. (Show all computations.)

P3-5A On September 1, 2008, the account balances of Rand Equipment Repair, Inc. were as follows.

No. Debits No. Credits 101 Cash $ 4,880 154 Accumulated Depreciation $ 1,500 112 Accounts Receivable 3,520 201 Accounts Payable 3,400 126 Supplies 2,000 209 Unearned Service Revenue 1,400 153 Store Equipment 15,000 212 Salaries Payable 500

311 Common Stock 15,000 320 Retained Earnings 3,600

$25,400 $25,400

Problems: Set A 131

(b) Net income $36,450 Ending retained earnings $24,950 Total assets $67,000

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

Preparing adjusting entries.

(SO 5, 6) 1. Salaries expense $2,320

2. Rent revenue $74,000

3. Advertising expense $4,800

4. Interest expense $6,300

Journalize transactions and follow through accounting cycle to preparation of finan- cial statements.

(SO 5, 6, 7)

During September the following summary transactions were completed.

Sept. 8 Paid $1,400 for salaries due employees, of which $900 is for September. 10 Received $1,200 cash from customers on account. 12 Received $3,400 cash for services performed in September. 15 Purchased store equipment on account $3,000. 17 Purchased supplies on account $1,200. 20 Paid creditors $4,500 on account. 22 Paid September rent $500. 25 Paid salaries $1,250. 27 Performed services on account and billed customers for services provided $1,500. 29 Received $650 from customers for future service.

Adjustment data consist of:

1. Supplies on hand $1,200. 2. Accrued salaries payable $400. 3. Depreciation is $100 per month. 4. Unearned service revenue of $1,450 is earned.

Instructions (a) Enter the September 1 balances in the ledger accounts. (b) Journalize the September transactions. (c) Post to the ledger accounts. Use J1 for the posting reference. Use the following accounts: No.

407 Service Revenue, No. 615 Depreciation Expense, No. 631 Supplies Expense, No. 726 Salaries Expense, and No. 729 Rent Expense.

(d) Prepare a trial balance at September 30. (e) Journalize and post adjusting entries. (f) Prepare an adjusted trial balance. (g) Prepare an income statement and a retained earnings statement for September and a bal-

ance sheet at September 30.

*P3-6A Givens Graphics Company, Inc. was organized on January 1, 2008, by Sue Givens. At the end of the first 6 months of operations, the trial balance contained the following accounts.

132 Chapter 3 Adjusting the Accounts

(d) Trial balance $30,150 (f) Adj. trial balance $30,650 (g) Net income $1,200

Ending retained earnings $4,800 Total assets $23,900

Debits Cash $ 9,500 Accounts Receivable 14,000 Equipment 45,000 Insurance Expense 1,800 Salaries Expense 30,000 Supplies Expense 3,700 Advertising Expense 1,900 Rent Expense 1,500 Utilities Expense 1,700

$109,100

Credits Notes Payable $ 20,000 Accounts Payable 9,000 Common Stock 22,000 Graphic Revenue 52,100 Consulting Revenue 6,000

$109,100

Analysis reveals the following additional data.

1. The $3,700 balance in Supplies Expense represents supplies purchased in January.At June 30, $1,300 of supplies was on hand.

2. The note payable was issued on February 1. It is a 9%, 6-month note. 3. The balance in Insurance Expense is the premium on a one-year policy, dated March 1,

2008. 4. Consulting fees are credited to revenue when received. At June 30, consulting fees of $1,500

are unearned.

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

(SO 5, 6, 7, 8)

Problems: Set B 133

MODINE CONSULTING, INC. Trial Balance May 31, 2008

Account Number Debit Credit

101 Cash $ 7,700 112 Accounts Receivable 4,000 126 Supplies 1,500 130 Prepaid Insurance 4,800 149 Office Furniture 9,600 201 Accounts Payable $ 3,500 209 Unearned Service Revenue 3,000 311 Common Stock 19,100 400 Service Revenue 6,000 726 Salaries Expense 3,000 729 Rent Expense 1,000

$31,600 $31,600

In addition to those accounts listed on the trial balance, the chart of accounts for Modine Consulting also contains the following accounts and account numbers: No. 150 Accumulated Depreciation—Office Furniture, No. 212 Salaries Payable, No. 229 Travel Payable, No. 631 Supplies Expense, No. 717 Depreciation Expense, No. 722 Insurance Expense, and No. 736 Travel Expense.

Other data:

1. $500 of supplies have been used during the month. 2. Travel expense incurred but not paid on May 31, 2008, $200. 3. The insurance policy is for 2 years. 4. $1,000 of the balance in the unearned service revenue account remains unearned at the end

of the month. 5. May 31 is a Wednesday, and employees are paid on Fridays. Modine Consulting has two em-

ployees, who are paid $700 each for a 5-day work week. 6. The office furniture has a 5-year life with no salvage value. It is being depreciated at $160 per

month for 60 months. 7. Invoices representing $1,000 of services performed during the month have not been recorded

as of May 31.

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

(SO 5, 6, 7)

(b) Adj. trial balance $112,850 (c) Net income $18,750

Ending retained earnings $18,750 Total assets $72,000

PROBLEMS: SET B P3-1B Linda Ace started her own consulting firm, Modine Consulting, Inc. on May 1, 2008. The trial balance at May 31 is as follows.

5. Graphic revenue earned but unrecorded at June 30 totals $2,000. 6. Depreciation is $2,000 per year.

Instructions (a) Journalize the adjusting entries at June 30. (Assume adjustments are recorded every 6 months.) (b) Prepare an adjusted trial balance. (c) Prepare an income statement and a retained earnings statement for the 6 months ended June

30 and a balance sheet at June 30.

Instructions (a) Prepare the adjusting entries for the month of May. Use J4 as the page number for your

journal. (b) Post the adjusting entries to the ledger accounts. Enter the totals from the trial balance as

beginning account balances and place a check mark in the posting reference column. (c) Prepare an adjusted trial balance at May 31, 2008.

P3-2B The Elston Motel, Inc. opened for business on May 1, 2008. Its trial balance before adjustment on May 31 is as follows.

ELSTON MOTEL, INC. Trial Balance May 31, 2008

Account Number Debit Credit

101 Cash $ 2,500 126 Supplies 1,900 130 Prepaid Insurance 2,400 140 Land 15,000 141 Lodge 70,000 149 Furniture 16,800 201 Accounts Payable $ 5,300 208 Unearned Rent 3,600 275 Mortgage Payable 40,000 311 Common Stock 55,000 429 Rent Revenue 9,200 610 Advertising Expense 500 726 Salaries Expense 3,000 732 Utilities Expense 1,000

$113,100 $113,100

In addition to those accounts listed on the trial balance, the chart of accounts for Elston Motel also contains the following accounts and account numbers: No. 142 Accumulated Depreciation—Lodge, No. 150 Accumulated Depreciation—Furniture, No. 212 Salaries Payable, No. 230 Interest Payable, No. 320 Retained Earnings, No. 619 Depreciation Expense— Lodge, No. 621 Depreciation Expense—Furniture, No. 631 Supplies Expense, No. 718 Interest Expense, and No. 722 Insurance Expense.

Other data:

1. Insurance expires at the rate of $200 per month. 2. A count of supplies shows $500 of unused supplies on May 31. 3. Annual depreciation is $3,600 on the lodge and $3,000 on furniture. 4. The mortgage interest rate is 12%. (The mortgage was taken out on May 1.) 5. Unearned rent of $2,500 has been earned. 6. Salaries of $800 are accrued and unpaid at May 31.

Instructions (a) Journalize the adjusting entries on May 31. (b) Prepare a ledger using the three-column form of account. Enter the trial balance amounts

and post the adjusting entries. (Use J1 as the posting reference.) (c) Prepare an adjusted trial balance on May 31. (d) Prepare an income statement and a retained earnings statement for the month of May and a

balance sheet at May 31.

134 Chapter 3 Adjusting the Accounts

Prepare adjusting entries, post, and prepare adjusted trial bal- ance, and financial statements.

(SO 5, 6, 7)

(c) Adj. trial balance $33,800

(c) Adj. trial balance $114,850 (d) Net income $3,850

Ending retained earnings $3,850 Total assets $106,450

P3-3B Ortega Co., Inc. was organized on July 1, 2008. Quarterly financial statements are pre- pared. The unadjusted and adjusted trial balances as of September 30 are shown below.

ORTEGA CO., INC. Trial Balance

September 30, 2008

Unadjusted Adjusted Dr. Cr. Dr. Cr.

Cash $ 6,700 $ 6,700 Accounts Receivable 400 900 Supplies 1,200 1,000 Prepaid Rent 1,500 900 Equipment 15,000 15,000 Accumulated Depreciation—Equipment $ 350 Notes Payable $ 5,000 5,000 Accounts Payable 1,510 1,510 Salaries Payable 600 Interest Payable 50 Unearned Rent 900 500 Common Stock 14,000 14,000 Dividends 600 600 Commission Revenue 14,000 14,500 Rent Revenue 400 800 Salaries Expense 9,000 9,600 Rent Expense 900 1,500 Depreciation Expense 350 Supplies Expense 200 Utilities Expense 510 510 Interest Expense 50

$35,810 $35,810 $37,310 $37,310

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

September 30 and a balance sheet at September 30. (c) If the note bears interest at 12%, how many months has it been outstanding?

P3-4B A review of the ledger of Yoda Company at December 31, 2008, produces the following data pertaining to the preparation of annual adjusting entries.

1. Prepaid Insurance $8,600. The company has separate insurance policies on its buildings and its motor vehicles. Policy B4564 on the building was purchased on July 1, 2007, for $6,000.The policy has a term of 3 years. Policy A2958 on the vehicles was purchased on January 1, 2008, for $3,600. This policy has a term of 2 years.

2. Unearned Subscriptions $49,000. The company began selling magazine subscriptions in 2008 on an annual basis. The magazine is published monthly. The selling price of a subscription is $50. A review of subscription contracts reveals the following.

Subscription Number of Date Subscriptions

October 1 200 November 1 300 December 1 480

980

3. Notes Payable $60,000. This balance consists of a note for 6 months at an annual interest rate of 9%, dated September 1.

Problems: Set B 135

Prepare adjusting entries and financial statements.

(SO 5, 6, 7)

(b) Net income $3,090 Ending retained earnings $2,490 Total assets $24,150

Prepare adjusting entries

(SO 5, 6) 1. Insurance expense $3,800

2. Subscription revenue $7,000

3. Interest expense $1,800

136 Chapter 3 Adjusting the Accounts

4. Salaries Payable $0.There are eight salaried employees. Salaries are paid every Friday for the current week. Five employees receive a salary of $500 each per week, and three employees earn $750 each per week. December 31 is a Wednesday. Employees do not work weekends.All employees worked the last 3 days of December.

Instructions Prepare the adjusting entries at December 31, 2008.

P3-5B On November 1,2008, the account balances of Rondeli Equipment Repair were as follows.

No. Debits No. Credits 101 Cash $ 2,790 154 Accumulated Depreciation $ 500 112 Accounts Receivable 2,510 201 Accounts Payable 2,100 126 Supplies 2,000 209 Unearned Service Revenue 1,400 153 Store Equipment 10,000 212 Salaries Payable 500

311 Common Stock 10,000 320 Retained Earnings 2,800

$17,300 $17,300

During November the following summary transactions were completed.

Nov. 8 Paid $1,100 for salaries due employees, of which $600 is for November. 10 Received $1,200 cash from customers on account. 12 Received $1,400 cash for services performed in November. 15 Purchased store equipment on account $3,000. 17 Purchased supplies on account $500. 20 Paid creditors on account $2,500. 22 Paid November rent $300. 25 Paid salaries $1,300. 27 Performed services on account and billed customers for services provided $400. 29 Received $550 from customers for future service.

Adjustment data consist of:

1. Supplies on hand $500. 2. Accrued salaries payable $500. 3. Depreciation for the month is $100. 4. Unearned service revenue of $1,150 is earned.

Instructions (a) Enter the November 1 balances in the ledger accounts. (b) Journalize the November transactions. (c) Post to the ledger accounts. Use J1 for the posting reference. Use the following accounts: No.

407 Service Revenue, No. 615 Depreciation Expense, No. 631 Supplies Expense, No. 726 Salaries Expense, and No. 729 Rent Expense.

(d) Prepare a trial balance at November 30. (e) Journalize and post adjusting entries. (f) Prepare an adjusted trial balance. (g) Prepare an income statement and a retained earnings statement for November and a balance

sheet at November 30.

Journalize transactions and follow through accounting cycle to preparation of finan- cial statements.

(SO 5, 6, 7)

(d) Trial balance $20,150 (f) Adj. trial balance $20,750 (g) Net loss $1,850; Ending

retained earnings $950 Total assets $15,350

PROBLEMS: SET C Visit the book’s website at www.wiley.com/college/weygandt, and choose the Student Companion site, to access Problem Set C.

4. Salaries expense $2,850

(Note: This is a continuation of the Cookie Chronicle from Chapters 1 and 2.)

CCC3 It is the end of November and Natalie has been in touch with her grandmother. Her grandmother asked Natalie how well things went in her first month of business. Natalie, too,

CONTINUING COOKIE CHRONICLE

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Financial Reporting Problem PepsiCo, Inc. BYP3-1 The financial statements of PepsiCo are presented in Appendix A at the end of this textbook.

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

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

result in adjusting entries for accruals. (c) Using the Selected Financial Data and 5-Year Summary, what has been the trend since 2001

for net income?

Comparative Analysis Problem PepsiCo, Inc. vs. The Coca-Cola Company BYP3-2 PepsiCo’s financial statements are presented in Appendix A. Coca-Cola’s financial statements are presented in Appendix B.

Instructions Based on information contained in these financial statements, determine the following for each company.

(a) Net increase (decrease) in property, plant, and equipment (net) from 2004 to 2005. (b) Increase (decrease) in selling, general, and administrative expenses from 2004 to 2005. (c) Increase (decrease) in long-term debt (obligations) from 2004 to 2005. (d) Increase (decrease) in net income from 2004 to 2005. (e) Increase (decrease) in cash and cash equivalents from 2004 to 2005.

Exploring the Web BYP3-3 A wealth of accounting-related information is available via the Internet. For exam- ple the Rutgers Accounting Web offers access to a great variety of sources.

Address: www.accounting.rutgers.edu/ or go to www.wiley.com/college/weygandt

Steps: Click on Accounting Resources. (Note: Once on this page, you may have to click on the text only box to access the available information.)

Instructions (a) List the categories of information available through the Accounting Resources page. (b) Select any one of these categories and briefly describe the types of information available.

BROADENING YOUR PERSPECTIVE FINANCIAL REPORTING AND ANALYSIS

Broadening Your Perspective 137

would like to know if she has been profitable or not during November. Natalie realizes that in order to determine Cookie Creations’ income, she must first make adjustments.

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138 Chapter 3 Adjusting the Accounts

CRITICAL THINKING Decision Making Across the Organization BYP3-4 Happy Camper Park Inc. was organized on April 1, 2007, by Amaya Berge. Amaya is a good manager but a poor accountant. From the trial balance prepared by a part-time bookkeeper, Amaya prepared the following income statement for the quarter that ended March 31, 2008.

HAPPY CAMPER PARK INC. Income Statement

For the Quarter Ended March 31, 2008

Revenues Rental revenue $90,000

Operating expenses Advertising $ 5,200 Wages 29,800 Utilities 900 Depreciation 800 Repairs 4,000

Total operating expenses 40,700

Net income $49,300

Amaya thought that something was wrong with the statement because net income had never exceeded $20,000 in any one quarter. Knowing that you are an experienced accountant, she asks you to review the income statement and other data.

You first look at the trial balance. In addition to the account balances reported above in the income statement, the ledger contains the following additional selected balances at March 31, 2008.

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

You then make inquiries and discover the following.

1. Rental revenues include advanced rentals for summer occupancy $15,000. 2. There were $1,700 of supplies on hand at March 31. 3. Prepaid insurance resulted from the payment of a one-year policy on January 1, 2008. 4. The mail on April 1, 2008, brought the following bills: advertising for week of March 24, $110;

repairs made March 10, $260; and utilities, $180. 5. There are four employees, who receive wages totaling $300 per day. At March 31, 2 days’

wages have been incurred but not paid. 6. The note payable is a 3-month, 10% note dated January 1, 2008.

Instructions With the class divided into groups, answer the following.

(a) Prepare a correct income statement for the quarter ended March 31, 2008. (b) Explain to Amaya the generally accepted accounting principles that she did not recognize in

preparing her income statement and their effect on her results.

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

Instructions Write a memo to Keri Ann Nickels, the owner of Keri Ann Co., that explains the following: the nature and purpose of adjusting entries, why adjusting entries are needed, and the types of adjusting entries that may be made.

Ethics Case BYP3-6 Bluestem Company is a pesticide manufacturer. Its sales declined greatly this year due to the passage of legislation outlawing the sale of several of Bluestem’s chemical pesticides. In the coming year, Bluestem will have environmentally safe and competitive chemicals to re- place these discontinued products. Sales in the next year are expected to greatly exceed any prior year’s. The decline in sales and profits appears to be a one-year aberration. But even so, the company president fears a large dip in the current year’s profits. He believes that such a dip could cause a significant drop in the market price of Bluestem’s stock and make the company a takeover target.

To avoid this possibility, the company president calls in Cathi Bell, controller, to discuss this period’s year-end adjusting entries. He urges her to accrue every possible revenue and to defer as many expenses as possible. He says to Cathi, “We need the revenues this year, and next year can easily absorb expenses deferred from this year. We can’t let our stock price be ham- mered down!” Cathi didn’t get around to recording the adjusting entries until January 17, but she dated the entries December 31 as if they were recorded then. Cathi also made every effort to comply with the president’s request.

Instructions (a) Who are the stakeholders in this situation? (b) What are the ethical considerations of (1) the president’s request and (2) Cathi’s dating the

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

“All About You” Activity BYP3-7 In the “All About You” feature in this chapter (p. 115), you learned how important it is that companies report or disclose information about all liabilities, including potential liabili- ties related to environmental clean-up. There are many situations in which you will be asked to provide personal financial information about your assets, liabilities, revenue, and expenses. Some- times you will face difficult decisions regarding what to disclose and how to disclose it.

Instructions Suppose that you are putting together a loan application to purchase a home. Based on your in- come and assets, you qualify for the mortgage loan, but just barely. How would you address each of the following situations in reporting your financial position for the loan application? Provide responses for each of the following questions. (a) You signed a guarantee for a bank loan that a friend took out for $20,000. If your friend doesn’t

pay, you will have to pay. Your friend has made all of the payments so far, and it appears he will be able to pay in the future.

(b) You were involved in an auto accident in which you were at fault.There is the possibility that you may have to pay as much as $50,000 as part of a settlement.The issue will not be resolved before the bank processes your mortgage request.

(c) The company at which you work isn’t doing very well, and it has recently laid off employees. You are still employed, but it is quite possible that you will lose your job in the next few months.

Answers to Insight and Accounting Across the Organization Questions How Long Will “The Force” Be with Us?, p. 96 Q: What accounting principle does this example illustrate? A: This situation demonstrates the difficulty of matching expenses to revenues. Q: How will financial results be affected if the expenses are recognized over a period that is less

than that used for revenues? A: If expenses are recognized over a period that is less than that used for revenues, earnings will

be understated during the early years and overstated during the later years. Q: What if the expenses are recognized over a period that is longer than that used for revenues? A: If the expenses are recognized over a period that is longer than that used for revenues, earnings

will be overstated during the early years and understated in later years. In either case, manage- ment and stockholders could be misled.

Broadening Your Perspective 139

Companies Change Advertising Treatment, p. 100 Q: Why might the new accounting method cause companies sometimes to spend less on

advertising? A: Under the old approach companies could delay to future periods the expensing of advertising

costs. Under that approach, money spent this period did not necessarily immediately reduce in- come. Under the new approach, a dollar spent on advertising immediately reduces this year’s income. If the company is concerned that it might not hit this year’s earnings target, it might de- cide to reduce its advertising spending.

Turning Gift Cards into Revenue, p. 104 Q: Suppose that Robert Jones purchases a $100 gift card at Best Buy on December 24, 2007, and

gives it to his wife, Devon, on December 25, 2007. On January 3, 2008, Devon uses the card to purchase $100 worth of CDs. When do you think Best Buy should recognize revenue, and why?

A: According to the revenue recognition principle, companies should recognize revenue when earned. In this case revenue is not earned until Best Buy provides the goods. Thus, when Best Buy receives cash in exchange for the gift card on December 24, 2007, it should recognize a li- ability, Unearned Revenue, for $100. On January 3, 2008, when Devon Jones exchanges the card for merchandise, Best Buy should recognize revenue and eliminate $100 from the balance in the Unearned Revenue account.

Authors’ Comments on All About You: Is Your Old Computer a Liability?, p. 115 The balance sheet should provide a fair representation of what a company owns and what it owes. If significant obligations of the company are not reported on the balance sheet, the com- pany’s net worth (its equity) will be overstated. While it is true that it is not possible to estimate the exact amount of future environmental clean-up costs, it is becoming clear that companies will be held accountable.

Therefore, it doesn’t seem reasonable to not accrue for environmental costs. Recognition of these liabilities provides a more accurate picture of the company’s financial position. It also has the potential to improve the environment. As companies are forced to report these amounts on their financial statements, they will start to look for more effective and efficient means to reduce toxic waste, and therefore reduce their costs.

Answer to PepsiCo Review It Question 4, p. 104 Per Note 4, PepsiCo’s 2005 depreciation expense is $1,103 million; 2004 depreciation expense was $1,062 million.

Answers to Self-Study Questions 1. c 2. a 3. d 4. d 5. d 6. c 7. a 8. b 9. b 10. c *11. a

140 Chapter 3 Adjusting the Accounts

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