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Chapter 4: ANSWERS TO QUESTIONS

1. (a)Under the periodicity assumption, an accountant is required to determine the effect ofeach accounting transaction on a specific accounting period.

(b)An accounting time period that is one year in length is referred to as a fiscal year.

2. The two generally accepted accounting principles that pertain to adjusting the accounts are:The revenue recognition principle, which states that revenue should be recognized in thetime period in which the performance obligation is satisfied.The expense recognition principle, which states that expenses be matched with revenuesin the period when the company makes efforts to generate those revenues.

3. The law firm should recognize the revenue in April. The revenue recognition principlestates that revenue should be recognized in the accounting period in which theperformance obligation is satisfied.

4. Expenses of $4,700 should be deducted from the revenues in April. Under the expenserecognition principle efforts (expenses) should be matched with results (revenues).

5. No, adjusting entries are required by the revenue and expense recognition principles.

6. The financial information in a trial balance may not be up-to-date because:(1)Some events are not journalized daily because it is not useful or efficient to do so.(2) The expiration of some costs occurs with the passage of time rather than as a result

of recurring daily transactions.(3) Some items may be unrecorded because the transaction data are not known.

7. The two categories of adjusting entries are deferrals and accruals. Deferrals consist ofrevenues collected before services are provided and expenses paid before they areincurred. Accruals consist of revenues for services performed prior to collection andexpenses incurred prior to payment.

8. In a prepaid expense adjusting entry, expenses are debited and assets are credited.9. No. Depreciation is the process of allocating the cost of an asset to expense over its

useful life. Depreciation results in the presentation of the book value of the asset, not itsfair value.

10. Depreciation expense is an expense account whose normal balance is a debit. Thisaccount shows the cost that has expired during the current accounting period.Accumulated depreciation is a contra asset account whose normal balance is a credit.The balance in this account is the depreciation that has been recognized from the date ofacquisition to the balance sheet date.

11. Equipment................................................................................ $15,000Less: Accumulated depreciationequipment.......................... 7,000 $8,000

12. In an unearned revenue adjusting entry, liabilities are debited and revenues are credited.

13. The sale of a three-year maintenance contract on December 29, 2013 will have no effecton the 2013 income statement but receipt of $100,000 on December 29, 2013, 2014, and2015 will increase an asset, Cash, and a liability, Unearned Service Revenue. As AceTechnologies provides service to its customer during 2014, 2015, and 2016, the liabilitywill decrease and revenue will be recognized. Accrual accounting rules require thatrevenue be recognized as the performance obligation is satisfied rather than when cash isreceived.

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Questions Chapter 4(Continued)

14. This promotion plan sounds like a bad idea for two reasons:(1)GAAP requires that the sale of a gift card be recorded as Unearned Sales Revenue(a liability) rather than Sales Revenue. Revenue recognition is delayed until the giftcard is used or expires. Steves plan will not help the company meet its target

revenue unless customers use the cards by year-end.(2)Selling a $50 card for $45 will probably not help the company meet its target netincome. Although this promotion may result in additional sales revenue as the cardsare used, the income resulting from the cards will be much less than usual since theyeliminate $5 of normal gross profit.

15. An asset is debited and a revenue is credited.

16. An expense is debited and a liability is credited.

17. Net income was understated $270 because prior to adjustment revenues are understatedby $780 and expenses are understated by $510. The difference in this case is $270 ($780 $510).

18. The entry is:Jan. 9 Salaries and Wages Expense........................................ 5,100

Salaries and Wages Payable......................................... 1,100Cash..................................................................... 6,200

19. (a)Accrued revenues. (d)Accrued expenses or prepaid expenses.(b)Unearned revenues. (e)Prepaid expenses.(c) Accrued expenses. (f) Accrued revenues or unearned revenues.

20. (a)Salaries and Wages Payable. (d)Supplies Expense.(b)Accumulated Depreciation. (e)Service Revenue.(c) Interest Expense. (f) Service Revenue.

21. Disagree. An adjusting entry affects only one balance sheet account and one incomestatement account.

22. Tootsie Roll reports Accounts Receivable. This suggests that it records revenue when ithas delivered goods, even though it hasnt received payment. If it used a cash basis itwouldnt record revenue until cash was received, and it would therefore not establishreceivables.

23. Financial statements can be prepared from an adjusted trial balance because thebalances of all accounts have been adjusted to show the effects of all financial events thathave occurred during the accounting period.

24. (a) Information presented on an accrual basis is useful because it reveals important

information about the relationship between efforts and results. This information isuseful in predicting future results. Trends in revenues and expenses are thus moremeaningful.

(b)Information presented on a cash basis is useful for predicting the future availability ofcash. Cash basis financial statements provide useful information about a companyssources and uses of cash.

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25. The amount shown in the adjusted trial balance column for an account equals the account

balance in the ledger after adjusting entries have been journalized and posted.

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Questions Chapter 4(Continued)

26.(1) (Dr) Individual revenue accounts and (Cr) Income Summary.(2) (Dr) Income Summary and (Cr) Individual expense accounts.(3) (Dr) Income Summary and (Cr) Retained Earnings (for net income).(4) (Dr) Retained Earnings and (Cr) Dividends.

27.Financial information is used by managers to direct and evaluate a companysperformance. The sooner such information is made available; the sooner changes can bemade to get a company back on track. A virtual close speeds up the reporting processand allows managers to react much faster to changing economic conditions.

28.Income Summary is a temporary account that is used in the closing process. The accountis debited for expenses and credited for revenues. The difference, either net income or netloss, is then closed to Retained Earnings.

29.The post-closing trial balance contains only balance sheet accounts. Its purpose is to provethe equality of the permanent account balances that the company carries forward into thenext accounting period.

30.The accounts that will not appear in the post-closing trial balance are: DepreciationExpense; Dividends; and Service Revenue.

31.The steps that involve journalizing are (1) journalize the transactions, (2) journalize theadjusting entries, and (3) journalize the closing entries.

32.The three trial balances are the (1) trial balance, (2) adjusted trial balance, and (3) post-closing trial balance.

33.Earnings management is the planned timing of revenues, expenses, gains, and losses tosmooth out bumps in net income. Such action is undertaken to help a company meet targetfinancial numbers.

Quality of earnings indicates the level of full and transparent information that a companyprovides to users of financial statements.

34.Examples of ways a company can manage earnings include the following.

Use of one-time items to prop up earnings numbers. A company may decide to sellproperty that has appreciated in value in order to record a gain on the sale. Such a gainwill increase the current years net income but future income will probably not include asimilar increase.

Inflating revenue in the short-run to the detriment of the long-run. A company mayimplement changes in its promotion activities near the end of an accounting period toboost year-end revenues. Offering a special rebate or a twoforone package is likely toincrease sales for the time the promotion runs but usually results in lower sales insubsequent periods. Savvy customers may even postpone purchases until special dealsare available.

Recording improper adjusting entries. Some adjusting entries require estimates andjudgment to properly recognize revenue and match expenses. By recognizing revenuesooner and delaying the recognition of expenses, earnings can be overstated in earlyperiods and understated in subsequent periods. This type of management is mostprevalent with multi-year contracts and prepaid expenses.

*35.The worksheet is a working paper designed to make it easier to prepare adjusting entriesand financial statements.

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*36.The columns of the worksheet from left to right are two columns each for the trial balance,adjustments, adjusted trial balance, income statement, and balance sheet.

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SOLUTIONS TO BRIEF EXERCISES

BRIEF EXERCISE 4-1

Cash Net Income(a)(b)(c)(d)(e)(f)

$10000

+8002,500

0

$020+1,300

00

600

BRIEF EXERCISE 4-2

(a)Prepaid Insuranceto recognize insurance expired during theperiod.

(b)Depreciation Expenseto allocate the cost of an asset toexpense during the current period.

(c)Unearned Service Revenueto account for unearned revenue forwhich services were provided during the period.

(d)Interest Payableto recognize interest accrued but unpaid onnotes payable during the current period.

BRIEF EXERCISE 4-3

Item(1)

Type of Adjustment(2)

Accounts Before Adjustment

(a) Prepaid Expenses Assets Overstated

Expenses Understated(b) Accrued Revenues Assets Understated

Revenues Understated

(c) Accrued Expenses Expenses UnderstatedLiabilities Understated

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(d) Unearned Revenues Liabilities OverstatedRevenues Understated

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BRIEF EXERCISE 4-4

Dec. 31 Supplies Expense............................................. 7,700Supplies..................................................... 7,700

Supplies Supplies Expense8,800 12/31 7,700 12/31 7,700

12/31 Bal.1,100

BRIEF EXERCISE 4-5

Dec. 31 Depreciation Expense...................................... 2,750Accumulated DepreciationEquipment

.............................................. 2,750

Depreciation ExpenseAccumulated Depreciation

Equipment12/31 2,750 12/31 2,750

Balance Sheet:Equipment................................................................... $22,000

Less: Accumulated depreciationequipment....... 2,750

$19,250

BRIEF EXERCISE 4-6

July 1 Prepaid Insurance............................................. 12,400Cash...........................................................

12,400

Dec.31 Insurance Expense ($12,400 X 6/24)............... 3,100Prepaid Insurance.....................................

3,100

Prepaid Insurance Insurance Expense7/1 12,400 12/31 3,100 12/31 3,100

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12/31 Bal.9,300

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BRIEF EXERCISE 4-7

July 1 Cash................................................................... 12,400Unearned Service Revenue......................

12,400

Dec.31 Unearned Service Revenue............................. 3,100Service Revenue ($12,400 X 6/24)............ 3,100

Unearned Service Revenue Service Revenue12/31 3,100 7/1 12,400 12/31 3,100

12/31 Bal.9,300

BRIEF EXERCISE 4-8

(a)Dec. 31 Interest Expense....................................... 300Interest Payable.................................

300

(b) 31 Accounts Receivable................................ 1,700Service Revenue................................

1,700

(c) 31 Salaries and Wages Expense................... 780

Salaries and Wages Payable............780

BRIEF EXERCISE 4-9

Account(1)

Type of Adjustment(2)

Related Account

(a) Accounts Receivable Accrued Revenues Service Revenue

(b) Prepaid Insurance Prepaid Expenses Insurance Expense

(c) Equipment Not required

(d) Accum. DepreciationEquipment

Prepaid Expenses Depreciation Expense

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(e) Notes Payable Not required

(f) Interest Payable Accrued Expenses Interest Expense

(g) Unearned Service

Revenue

Unearned Revenues Service Revenue

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BRIEF EXERCISE 4-10

RAVINE CORPORATIONIncome Statement

For the Year Ended December 31, 2014

RevenuesService revenue......................................................$32,000

ExpensesSalaries and wages expense................................. $14,000Rent expense.......................................................... 3,900

Insurance expense................................................. 1,800

Supplies expense................................................... 1,500

Depreciation expense............................................ 1,000Total expenses................................................

22,200Net income.....................................................................9,800

BRIEF EXERCISE 4-11

RAVINE CORPORATIONRetained Earnings Statement

For the Year Ended December 31, 2014

Retained earnings, January 1..........................................................$17,200

Add: Net income.............................................................................10,400

27,600Less: Dividends...............................................................................6,000Retained earnings, December 31.....................................................

$21,600

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BRIEF EXERCISE 4-12

Account

(a)(b)(c)(d)(e)(f)(g)

Accumulated DepreciationDepreciation ExpenseRetained Earnings (beginning)DividendsService RevenueSuppliesAccounts Payable

Balance SheetIncome StatementRetained Earnings StatementRetained Earnings StatementIncome StatementBalance SheetBalance Sheet

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BRIEF EXERCISE 4-13

The accounts that will appear in the post-closing trial balance are:

Accumulated DepreciationRetained Earnings (ending)SuppliesAccounts Payable

BRIEF EXERCISE 4-14

(a) Closing EntriesJuly 31 Service Revenue....................................... 16,000

Income Summary...............................16,000

(To close revenue account)

Income Summary...................................... 11,900Salaries and Wages Expense........... 8,400Maintenance and RepairsExpense........................................... 2,500Income Tax Expense......................... 1,000(To close expense accounts)

Income Summary...................................... 4,100Retained Earnings............................. 4,100(To close net income toretained earnings)

Retained Earnings.................................... 1,300Dividends............................................ 1,300(To close dividends to retained

earnings)

(b)Retained Earnings

1,300 7/1 Bal. 20,000

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4,1007/31 Bal.22,800

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BRIEF EXERCISE 4-15

The proper sequencing of the required steps in the accounting cycleis as follows:

1. (c) Analyze business transactions.2. (e) Journalize the transactions.3. (i) Post to ledger accounts.4. (d) Prepare a trial balance.5. (h) Journalize and post adjusting entries.6. (b) Prepare an adjusted trial balance.7. (g) Prepare financial statements.8. (f) Journalize and post closing entries.9. (a) Prepare a post-closing trial balance.

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SOLUTIONS TO DO IT! REVIEW EXERCISES

DO IT! 4-1

1. Insurance Expense......................................................... 300Prepaid Insurance....................................................(To record insurance expired)

2. Supplies Expense........................................................... 1,600Supplies....................................................................

1,600(To record supplies used)

3. Depreciation Expense.................................................... 200

Accumulated DepreciationEquipment...............(To record monthly depreciation)

4. Unearned Service Revenue........................................... 4,000Service Revenue......................................................

4,000(To record revenue for services provided)

DO IT! 4-2

1. Salaries and Wages Expense........................................ 1,100Salaries and Wages Payable...................................

1,100(To record accrued salaries)

2. Interest Expense ($20,000 X .09 X 1/12)........................ 150Interest Payable........................................................(To record accrued interest)

3. Accounts Receivable .................................................... 1,600Service Revenue......................................................

1,600(To record revenue for service provided)

DO IT! 4-3

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Income statement: Service Revenue, Utilities Expense

Balance sheet: Accounts Receivable, Accumulated Depreciation,Notes Payable, Common Stock.

DO IT! 4-4

Dec. 31Income Summary......................................................36,000Retained Earnings..............................................

36,000(To close net income to retained earnings)

Dec. 31Retained Earnings.....................................................22,000Dividends............................................................22,000

(To close dividends to retained earnings)

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SOLUTIONS TO EXERCISES

EXERCISE 4-1

The revenue recognition principle requires that companies recognizerevenue in the accounting period in which the performance obligationis satisfied.

(a)Since the sales effort is not complete until the flight actuallyoccurs, revenue should not be recognized until December.Southwest Airlines should recognize the revenue in Decemberwhen the customer has been provided with the flight.

(b)Sales revenue should be recognized at the time of delivery.

(c)Revenue should be recognized on a per game basis over theseason from April through October.

(d)Interest revenue should be accrued and recognized by RBC evenlyover the term of the loan.

(e)Revenue should be recognized when the sweater is shipped tothe customer in September.

EXERCISE 4-2

(a) 8. Going concern assumption.(b) 1. Economic entity assumption.(c) 7. Full disclosure principle.(d) 3. Monetary unit assumption.(e) 6. Materiality.(f) 4. Periodicity assumption.(g) 2. Expense recognition principle.(h) 5. Historical cost principle.

EXERCISE 4-3

(a) Revenue recognition principle.(b) Periodicity assumption.(c) No violation.(d) Going concern assumption.

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(e) Historical cost principle.(f) Economic entity assumption.

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EXERCISE 4-4

$ 33,640 Cash basis earnings.

+3,400

Accounts receivable arise from sales that have been made,

thus revenue must be recognized for balance outstanding atthe end of the current year.

2,800Accounts receivable collected in current year, for sales madein previous year must be deducted from earnings.

+1,300Supplies on hand at year end should be set up as an assetrather than expensed, this increases earnings.

1,460Supplies on hand at the end of the previous year should beexpensed this year, this decreases earnings.

2,000Wages owing at the end of the current year should beaccrued, thus reducing earnings.

+2,400Wages owed at the end of the previous year should not bededucted from the current years earnings, thus increasingearnings.

1,400Other unpaid amounts owed at the end of the current yearshould be accrued, thus reducing earnings.

+1,100Other unpaid amounts owed at the end of the previous yearshould not be deducted from the current years earnings, thusincreasing earnings.

$ 34,180 Accrual basis earnings.

EXERCISE 4-5

(a) Cash Basis Accrual BasisService Revenue

Operating Expenses Insurance ExpenseNet Income

$22,00012,0002,400

$7,600

$28,00015,800 $12,200

(b)The accrual basis of accounting provides more usefulinformation for decision makers because it recognizes revenueswhen the performance obligation is satisfied and expenses whenincurred.

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EXERCISE 4-6

(a) KAFFEN COMPANYIncome Statement

For the Six Months Ended April 30, 2014

RevenuesService revenue ($32,150 + $540)....................$32,690

ExpensesIncome tax expense.......................................... $10,000Salaries and wages expense ($2,600 + $420). 3,020Depreciation expense [($9,200 4) X 6/12]..... 1,150

Rent expense ($1,225 $175)........................... 1,050

Utilities expense................................................ 970Advertising expense......................................... 375Total expenses............................................

16,565Net income................................................................

$16,125

(b) KAFFEN COMPANYBalance Sheet

April 30, 2014

AssetsCurrent AssetsCash................................................................. $27,780Accounts receivable....................................... 540Prepaid rent.................................................... 175

Total current assets................................$28,495

Property, plant, and equipmentEquipment....................................................... 9,200Less: Accumulateddepreciationequipment........................... 1,150

8,050Total assets..............................................

$36,545

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Liabilities and Stockholders EquityCurrent Liabilities

Salaries and wages payable.........................420Stockholders equity

Common stock............................................... $20,000Retained earnings......................................... 16,125

Total stockholders equity...............36,125

Total liabilities and stockholdersequity....................................................

$36,545

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EXERCISE 4-7

(a)Event Cash Accounting Accrual Accounting180-day financingfor customers

Revenue is recorded ascash is received.

Revenue is recorded as itis earned. VidGamrecords revenue (and areceivable) as soon asservices are provided butmay wait up to 180 days toreceive cash.

Payment toequipmentsuppliers upon

delivery of goods

Equipment expense isrecorded as anexpense as soon as

equipment is receivedand paid for.

Equipment is recorded asan asset and depreciated.

Prepayment for 2years ofinsurancecoverage

Insurance expense isrecorded as soon aspayment is made.

Prepayment is recordedas an asset andrecognized as an expenseas time passes.

One monthssalaries owed atyear-end

No salary expense isrecorded until salariesare paid.

Salary expense isrecorded as employeesperform work. Amountsowed at year-end would berecorded as a liability.

Proper accrual accounting would require adjusting entries fordepreciation, prepaid insurance and accrued salaries.

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EXERCISE 4-7 (Continued)

(b)Accrual accounting rules require that revenue be recognized as acompany performs services and expenses be matched with therevenue they help produce. Receipt or payment of cash does notinfluence the calculation of net income.

VidGam has provided many services during the year and thus haspositive net income. Since VidGam allowed its largest customersto take up to 180 days to pay, but was forced to pay cash for allpurchases, it is likely that the company has very little cash atyear-end. New companies frequently experience cash shortagesbecause they extend credit to attract customers but are unable toreceive credit from their suppliers. As time passes, the cash

supply should increase as payments on accounts receivablecome in and offset current purchases.

EXERCISE 4-8

Item(1)

Type of Adjustment(2)

Accounts Before Adjustment

(a) Accrued Revenues Assets Understated

Revenues Understated

(b) Prepaid Expenses Assets OverstatedExpenses Understated

(c) Accrued Expenses Expenses UnderstatedLiabilities Understated

(d) Unearned Revenues Liabilities OverstatedRevenues Understated

(e) Accrued Expenses Expenses UnderstatedLiabilities Understated

(f) Prepaid Expenses Assets OverstatedExpenses Understated

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EXERCISE 4-9

1. Mar. 31Depreciation Expense ($280 X 3)....................... 840Accumulated DepreciationEquipment

...........................................840

2. 31 Unearned Rent Revenue............................... 6,200Rent Revenue ($12,400 X 1/2)................

6,200

3. 31 Interest Expense............................................ 400Interest Payable......................................

400

4. 31 Supplies Expense.......................................... 2,150Supplies ($3,000 $850)........................

2,150

5. 31 Insurance Expense ($400 X 3)...................... 1,200Prepaid Insurance..................................

1,200

EXERCISE 4-10

1. Jan.31 Accounts Receivable..................................... 760Service Revenue....................................

760

2. 31 Utilities Expense............................................ 450Accounts Payable..................................

450

3. 31 Depreciation Expense................................... 400Accumulated DepreciationEquipment

...........................................400

31 Interest Expense............................................ 500

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Interest Payable......................................500

4. 31 Insurance Expense ($24,000 12)................ 2,000Prepaid Insurance..................................

2,000

5. 31 Supplies Expense ($1,750 $550)................ 1,200Supplies..................................................

1,200