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The McGraw-Hill Companies, Inc., 2003 1

CHAPTER 4THE ACCOUNTING CYCLE:

ACCRUALS AND DEFERRALS

SUGGESTED ANSWERS TO DISCUSSION QUESTIONS

1. The purpose of making adjusting entries is to recognize certain revenue and expenses that are notproperly measured in the course of recording daily business transactions. These entries help achievethe goals of accrual accounting by recognizing revenue when it is earned and recognizing expenseswhen the related goods or services are used.

2. The only transactions that require end-of-period adjusting entries are those that affect the revenue orexpenses of more than one accounting period.Adjusting entries then are needed to apportion therevenue or expense among the affected accounting periods.

3. All adjusting entries affect bothan income statement account and a balance sheet account. Everyadjusting entry involves the recognition of either revenue or expense. Revenue and expensesrepresent changes in owners equity, which appears in the balance sheet. However, owners equity

cannot change by itself; there must also be a corresponding change in either assets or liabilities.4. Making adjusting entries requires a better understanding of accrual accounting than does the record-

ing of routine business transactions because there is no external evidence (such as bills or invoices)indicating the need for adjusting entries. Adjusting entries are necessary to reflect recorded costs thathave expired and recorded revenue that has been earned or to recognize previously unrecorded busi-ness activities. Thus, the need for adjusting entries is determined by the accountants understandingof the concepts of accrual accounting, not by external source documents.

5. Under accrual accounting, an expense is defined as the cost of goods and services used in the effort togenerate revenue. Thus, an expense is incurred when the related goods and services are used,notwhen the expense is paid. A 12-month insurance policy represents insurance coverage that is used upover a 12-month period. The cost of such a policy should be debited to an asset account and graduallyrecognized as an expense over the 12 months that the policy is in force.

6. Accrual accounting requires that revenue be recognized in the accounting records when it is earned. Ifrevenue has been earned, but not yet recorded in the accounts, an adjusting entry should be made toinclude this revenue in the income of the current period. This entry will credit a revenue account; asthe revenue has not yet been collected, the debit will be to an account receivable.

7. The term, unearned revenue,describes amounts that have been collected from customers in advanceand that have not yet been earned. As the company has an obligation to render services to thesecustomers or to refund their advance payments, unearned revenue appears in the liability section ofthe balance sheet. As services are performed for these customers, the liability is reduced. Therefore,an adjusting entry is made transferring the balance of the unearned revenue account into a revenueaccount.

8. Salaries Expense ................................................................................................16,000

Salaries Payable ..................................................................................... 16,000

To record salaries expense and related liability to employees for the last fourdays of the year (45 $20,000 = $16,000).

9. In the income statement, the Insurance Expense account will be understated; hence total expenses willbe understated, and net income will be overstated. In the balance sheet, the asset account, UnexpiredInsurance, will be overstated, as will the amount for total assets. Offsetting this overstatement ofassets will be an overstatement of retained earnings; hence owners equity will be overstated.

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10. Materialityrefers to the relative importance of an item or an event to the users of financial statements.An item is material if knowledge of it might reasonably influence the decisions of financialstatement users.

If an item is not material,by definition it is not relevantto decision makers. Therefore, the item maybe treated in the most convenient and economical manner by the preparer of the financial statements.Thus, the concept of materiality permits departures from other generally accepted accounting

principles in accounting for items that are not material.

11. The concept of materialitypermits accountants to handle items that are unlikely to influence thedecisions of users of the accounting information in the most convenient and economical manner.Charging the costs of low-priced and short-lived assets immediately to an expense is not likely toaffect the decisions of users of the financial statements. On the other hand, accounting for these itemsas assets and recording periodic depreciation would require time, effort, and cost. Thus, low-pricedand short-lived assets are routinely charged to an expense, because charging them to asset accountssimply is not worth the bother.

SOLUTIONS TO EXERCISES

Ex 41 a. Book value

b. Materiality

c. Matching principle

d. Unrecorded revenue

e. Adjusting entries

f. Unearned revenue

g. Prepaid expenses

h. None (This is an example of depreciation expense.)

Ex. 42Income Statement Balance Sheet

AdjustingEntry Revenue Expenses =

NetIncome Assets = Liabilities +

OwnersEquity

a NE I D D NE D

b NE I D NE I D

c I NE I I NE I

d NE I D NE I D

e NE I D D NE D

f I NE I NE D I

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Ex. 43 a. Rent Expense ....................................................................................... 240,000

Prepaid Rent............................................................................ 240,000

To record rent expense for May ($1,200,000 5 months =$240,000 per month).

b. Unearned Ticket Revenue .................................................................. 148,800

Ticket Revenue ........................................................................ 148,800To record earning portion of season ticket revenue relating to

May home games.

Ex. 45 a. (1) Interest Expense............................................................................ 375

Interest Payable ................................................................ 375

$50,000 x 9% annual rate x 1/12 = $375.

(2) Accounts Receivable..................................................................... 10,000

Consulting Fees Earned ................................................... 10,000

To record ten days of unbilled consulting fees at $1,000 perday.

b. $2,250 ($50,000 x 9% x 6/12 = $2,250)

c. $15,000 ($25,000 - $10,000 earned in December, 2002)

Ex. 46 a. At the time cash is collected by American Airlines for advance ticket sales, the entire

amount is accounted for as unearned revenue. The liability created represents the

deferral (or the postponement) of earned revenue until flight services are actually

provided to passengers.

b. Airlines normally reduce the balance of this liability account by converting it to

passenger revenue as services flight are provided. On some occasions, however, the

liability may be reduced as a result of making cash refunds to customers due to

cancellations.

c. Air Traffic Liability ............................................................................ 200,000

Passenger Revenue Earned ....................................................... 200,000

To record passenger revenue earned from advance ticket sales

for flights completed.

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Ex. 48 a. The total interest expense over the life of the note is $5,400 ($120,000 .09 612 =$5,400).

The monthly interest expense is $900 ($5,400 6 = $900).b. The liability to the bank at December 31, 2002, is $121,800 (Principal, $120,000 + $1,800

accrued interest).

c. 2002

Oct. 31 Cash .................................................................................... 120,000

Notes Payable......................................................... 120,000

Obtain from bank six-month loan with interest at 9%

a year.

d. Dec. 31 Interest Expense................................................................. 900

Interest Payable ..................................................... 900

To accrue interest expense for December on note

payable ($120,000 9% 112).

e. The liability to the bank at March 31, 2003, is $124,500, consisting of $120,000 principalplus $4,500 accrued interest for five months.

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Ex. 410 a. Materiality refers to the relative importanceof an item. An item is materialif knowledge

of it might reasonably influence the decisions of users of financial statements. If an item

is immaterial,by definition it is not relevantto decision makers.

Accountants must account for material items in the manner required by generally

accepted accounting principles. However, immaterial items may be accounted for in the

most convenient and economical manner.

b. Whether a specific dollar amount is material depends upon the (1) size of the amount

and (2) natureof the item. In evaluating the size of a dollar amount, accountants consider

the amount in relation to the size of the organization.

Based solely upon dollar amount, $2,500 is not material in relation to the financial

statements of a large, publicly owned corporation. For a small business however, this

amount could be material.

In addition to considering the size of a dollar amount, accountants must also consider

the natureof the item. The nature of an item may make the item material to users of

the financial statements regardlessof its dollar amount. Examples might include bribes

paid to government officials, or theft of company assets or other illegal acts committed

by management.

In summary, one cannot say whether $2,500 is a material amount. The answer depends

upon the related circumstances.

c. Two ways in which the concept of materiality may save time and effort for accountants

are:

1. Adjusting entries may be based upon estimated amounts if there is little or no

possibility that the use of an estimate will result in material error. For example, an

adjusting entry to reflect the amount of supplies used may be based on an estimate

of the cost of supplies remaining on hand.

2. Adjusting entries need not be made to accrue immaterial amounts of unrecordedexpenses or unrecorded revenue. For example, no adjusting entries normally are

made to record utility expense payable at year-end.

Ex. 411 a. None (or Materiality). Accounting for immaterial items is not wrong or a violation of

generally accepted accounting principles; it is merely a waste of time. The bookkeeper

is failing to take advantage of the concept of materiality, which permits charging im-

material costs directly to expense, thus eliminating the need to record depreciation in later

periods.

b. Matching.

c. Realization.

50 Minutes, Strong PROBLEM 45

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KEN HENSLEY ENTERPRISES, INC.a.

General Journal

(Adjusting Entries)

20__ (1)

Dec. 31 Accounts Receivable 4 4 0 0

Studio Revenue Earned 4 4 0 0

To record accrued studio revenue earned in December.

(2)

31 Supplies Expense 7 0 0

Studio Supplies 7 0 0

To record studio supplies used in December

($7,600 - $6,900).

(3)

31 Insurance Expense 2 5 0

Unexpired Insurance 2 5 0

To record December insurance expense ($1,500 x 1/6).

(4)

31 Studio Rent Expense 2 0 0 0

Prepaid Studio Rent 2 0 0 0

To record studio rent in December ($6,000 x 1/3).

(5)

31 Depreciation Expense: Recording Equipment 1 5 0 0

Accumulated Depreciation: Recording Equipment 1 5 0 0

To record depreciation expense in December

($90,000 x 1/60).

(6)

31 Interest Expense 1 2 0

Interest Payable 1 2 0

To record accrued interest expense in December.

($16,000 x 9% x 1/12).

(7)

31 Unearned Studio Revenue 3 6 0 0

Studio Revenue Earned 3 6 0 0

To record advance collections earned in December.

(8)

31 Salaries Expense 5 4 0

Salaries Payable 5 4 0

To record salaries accrued in December.

(9)

31 Income Taxes Expense 1 7 0 0

Income Taxes Payable 1 7 0 0

To record income taxes accrued in December.

($19,600 - $17,900).

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PROBLEM 45KEN HENSLEY ENTERPRISES, INC.

(concluded)b. Ken Hensley Enterprises, Inc.

Schedule of Income Earned

For the Year Ended December 31, 2002

Studio Revenue Earned $ 1 1 5 0 0 0

Salaries Expense $ 1 8 5 4 0

Supplies Expense 1 9 0 0

Insurance Expense 1 2 5 0

Depreciation Expense: Recording Equipment 1 8 0 0 0

Studio Rent Expense 2 3 0 0 0

Utilities Expense 2 3 5 0

Interest Expense 9 6 0

Income Taxes Expense 1 9 6 0 0

Total Expense 8 5 6 0 0

Net Income $ 2 9 4 0 0

c. Monthly rent expense for the last two months of 2002 was $2,000 ($6,000 3 months). The$21,000 rent expense shown in the studios trial balance includes a $2,000 rent expense for

November, which means that total rent expense for January through October was $19,000

($21,000 - $2,000). The monthly rent expense in these months must have been $1,900 ($19,000 10months). Thus, it appears that the studios monthly rent increased by $100 (from $1,900 to $2,000)

in November and December.

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15 Minutes, Medium PROBLEM 46KOYNE CORPORATION

Error TotalRevenue

TotalExpenses

NetIncome

TotalAssets

TotalLiabilities

OwnersEquity

a. Recorded a dividend as

an expense reported in

the income statement.

NE O U NE NE NE

b. Recorded the payment

of an account payable as

a debit to accounts

payable and a credit to

an expense account.

NE U O O NE O

c. Failed to record

depreciation expense.

NE U O O NE O

d. Recorded the issue of

capital stock as a debit to

cash and a credit to

retained earnings.

NE NE NE NE NE NE

e. Recorded the receipt of a

customer deposit as a

debit to cash and a credit

to fees earned.

O NE O NE U O

f. Failed to record expired

portion of an insurance

policy.

NE U O O NE O

g. Failed to record accrued

interest earned on an

outstanding note

receivable.

U NE U U NE U

211solutions4-03

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