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Unformatted text preview: 66124_c03_101-138.qxd 11/10/03 8:06 PM Page 101 3 THE MATCHING CONCEPT AND THE ADJUSTING PROCESS objectives After studying this chapter, you should be able to: PHOTO: © PHOTODISC GREEN/GETTY IMAGES 1 2 3 4 5 Explain how the matching concept relates to the accrual basis of accounting. Explain why adjustments are necessary and list the characteristics of adjusting entries. Journalize entries for accounts requiring adjustment. Summarize the adjustment process and prepare an adjusted trial balance. Use vertical analysis to compare financial statement items with each other and with industry averages. 66124_c03_101-138.qxd 11/10/03 8:06 PM Page 102 A ssume that you rented an apartment last month and signed a nine-month lease. When you signed the lease agreement, you were required to pay the final month’s rent of $500. This amount is not returnable to you. You are now applying for a student loan at a local bank. The loan application requires a listing of all your assets. Should you list the $500 deposit as an asset? The answer to this question is “yes.” The deposit is an asset to you until you receive the use of the apartment in the ninth month. A business faces similar accounting problems at the end of a period. A business must determine what assets, liabilities, and owner’s equity should be reported on its balance sheet. It must also determine what revenues and expenses should be reported on its income statement. As we illustrated in previous chapters, transactions are normally recorded as they take place. Periodically, financial statements are prepared, summarizing the effects of the transactions on the financial position and operations of the business. At any one point in time, however, the accounting records may not reflect all transactions. For example, most businesses do not record the daily use of supplies. Likewise, revenue may have been earned from providing services to customers, yet the customers have not been billed by the time the accounting period ends. Thus, at the end of the period, the revenue and receivable accounts must be updated. In this chapter, we describe and illustrate this updating process. We will focus on accounts that normally require updating and the journal entries that update them. The Matching Concept objective 1 Explain how the matching concept relates to the accrual basis of accounting. American Airlines uses the accrual basis of accounting. Revenues are recognized when passengers take flights, not when the passenger makes the reservation or pays for the ticket. A bank loan officer requires an individual, When accountants prepare financial who normally keeps records on a cash statements, they assume that the ecobasis, to list assets (automobiles, homes, nomic life of the business can be diinvestments, etc.) on an application for a vided into time periods. Using this loan or a line of credit. In addition, the accounting period concept, acapplication often asks for an estimate of the individual’s liabilities, such as outcountants must determine in which period the revenues and expenses of standing credit card amounts and automobile loan balances. In a sense, the loan application converts the the business should be reported. To individual’s cash-basis accounting system to an estidetermine the appropriate period, ac- mated accrual basis. The loan officer uses this informacountants will use either (1) the cash tion to assess the individual’s ability to repay the loan. basis of accounting or (2) the accrual basis of accounting. Under the cash basis, revenues and expenses are reported in the income statement in the period in which cash is received or paid. For example, fees are recorded when cash is received from clients, and wages are recorded when cash is paid to employees. The net income (or net loss) is the difference between the cash receipts (revenues) and the cash payments (expenses). Under the accrual basis, revenues are reported in the income statement in the period in which they are earned. For example, revenue is reported when the services are provided to customers. Cash may or may not be received from customers during this period. The concept that supports this reporting of revenues is called the revenue recognition concept. Under the accrual basis, expenses are reported in the same period as the revenues to which they relate. For example, employee wages are reported as an expense in the period in which the employees provided services to customers, and not necessarily when the wages are paid. The accounting concept that supports reporting revenues and related expenses in the same period is called the matching concept, or matching principle. Under this concept, an income statement will report the resulting income or loss for the period. 66124_c03_101-138.qxd 11/10/03 8:06 PM Page 103 Chapter 3 • The Matching Concept and the Adjusting Process 103 Generally accepted accounting principles require the use of the accrual basis. However, small service businesses may use the cash baThe matching concept sis because they have few receivables and payables. For example, attorneys, physicians, and real estate agents often use the cash basis. supports reporting revenues For them, the cash basis will yield financial statements similar to those and related expenses in the prepared under the accrual basis. For most large businesses, the cash basis will not provide accurate same period. financial statements for user needs. For this reason, we will emphasize the accrual basis in this text. The accrual basis and its related matching concept require an analysis and updating of some accounts when financial statements are prepared. In the following paragraphs, we will describe and illustrate this process, called the adjusting process. Nature of the Adjusting Process At the end of an accounting period, many of the balances of accounts in the ledger can be reported, without change, in the financial statements. For example, the balance of the cash account is normally the amount reported on the balance sheet. Explain why adjustments are necessary and list the characSome accounts in the ledger, however, require updating. For example, the balteristics of adjusting entries. ances listed for prepaid expenses are normally overstated because the use of these assets is not recorded on a day-to-day basis. The balance of the supplies account usually represents the cost of supplies at the beginning of the period plus the cost of supplies acquired during the period. To record the daily use of supplies would require many entries with small amounts. In addition, the total amount of supplies is small relative to other assets, and managers usually do not require day-to-day information about supplies. The journal entries that bring the accounts up to date at the end of the accounting period are called adjusting entries. All adjusting entries affect at least one income statement account and one balance All adjusting entries affect at sheet account. Thus, an adjusting entry will always involve a revenue or an expense account and an asset or a liability account. least one income statement Is there an easy way to know when an adjusting entry is needed? account and one balance Yes, four basic items require adjusting entries. The first two items are deferrals. Deferrals are created by recording a transaction in a way sheet account. that delays or defers the recognition of an expense or a revenue, as described below. objective 2 • Deferred expenses, or prepaid expenses, are items that have been initially recorded as assets but are expected to become expenses over time or through the normal operations of the business. Supplies and prepaid insurance are two examples of prepaid expenses that may require adjustment at the end of an accounting period. Other examples include prepaid advertising and prepaid interest. • Deferred revenues, or unearned revenues, are items that have been initially recorded as liabilities but are expected to become revenues over time or through the normal operations of the business. An example of deferred revenue is unearned rent. Other examples include tuition received in advance by a school, an annual retainer fee received by an attorney, premiums received in advance by an insurance company, and magazine subscriptions received in advance by a publisher. The second two items that require adjusting entries are accruals. Accruals are created by an unrecorded expense that has been incurred or an unrecorded revenue that has been earned, as described below. • Accrued expenses, or accrued liabilities, are expenses that have been incurred but have not been recorded in the accounts. An example of an accrued expense is accrued wages owed to employees at the end of a period. Other examples include accrued interest on notes payable and accrued taxes. 66124_c03_101-138.qxd 11/10/03 8:06 PM Page 104 104 Chapter 3 • The Matching Concept and the Adjusting Process • Accrued revenues, or accrued assets, are revenues that have been earned but have not been recorded in the accounts. An example of an accrued revenue is fees for services that an attorney has provided but hasn’t billed to the client at the end of the period. Other examples include unbilled commissions by a travel agent, accrued interest on notes receivable, and accrued rent on property rented to others. How do you tell the difference between deferrals and accruals? Determine when cash is received or paid, as shown in Exhibit 1. If cash is received (for revenue) or paid (for expense) in the current period, but the revenue or expense relates to a future period, the revenue or expense is a deferred item. If cash will not be received or paid until a future period, but the revenue or expense relates to the current period, the revenue or expense is an accrued item. •Exhibit 1 Deferrals and Accruals CURRENT ACCOUNTING PERIOD J A N.1 DEC.3 1 2005 2005 FUTURE ACCOUNTING PERIOD J A N.1 2006 DEC.3 1 2006 Deferrals Revenue earned or expense incurred Cash received or paid Accruals Revenue earned or expense incurred Cash received or paid Adjusting entries to record current period revenue or expense Recording Adjusting Entries objective 3 Journalize entries for accounts requiring adjustment. The examples of adjusting entries in the following paragraphs are based on the ledger of NetSolutions as reported in the December 31, 2005 trial balance in Exhibit 2. The adjusting entries are shown in color in T accounts to separate them from other transactions. An expanded chart of accounts for NetSolutions is shown in Exhibit 3. The additional accounts that will be used in this chapter are shown in color. 66124_c03_101-138.qxd 11/10/03 8:06 PM Page 105 Chapter 3 • The Matching Concept and the Adjusting Process •Exhibit 2 105 Unadjusted Trial Balance for NetSolutions NetSolutions Trial Balance December 31, 2005 Cash Accounts Receivable Supplies Prepaid Insurance Land Office Equipment Accounts Payable Unearned Rent Chris Clark, Capital Chris Clark, Drawing Fees Earned Wages Expense Rent Expense Utilities Expense Supplies Expense Miscelleous Expense •Exhibit 3 2 0 6 5 00 2 2 2 0 00 2 0 0 0 00 2 4 0 0 00 20 0 0 0 00 1 8 0 0 00 9 0 0 00 3 6 0 00 25 0 0 0 00 4 0 0 0 00 16 3 4 0 00 4 2 7 5 00 1 6 0 0 00 9 8 5 00 8 0 0 00 4 5 5 00 42 6 0 0 00 42 6 0 0 00 Expanded Chart of Accounts for NetSolutions Balance Sheet Accounts 11 12 14 15 17 18 19 21 22 23 31 32 1. Assets Cash Accounts Receivable Supplies Prepaid Insurance Land Office Equipment Accumulated Depreciation 2. Liabilities Accounts Payable Wages Payable Unearned Rent 3. Owner’s Equity Chris Clark, Capital Chris Clark, Drawing Income Statement Accounts 4. Revenue 41 Fees Earned 42 Rent Revenue 5. Expenses 51 Wages Expense 52 Rent Expense 53 Depreciation Expense 54 Utilities Expense 55 Supplies Expense 56 Insurance Expense 59 Miscellaneous Expense Deferred Expenses (Prepaid Expenses) The concept of adjusting the accounting records was introduced in Chapters 1 and 2 in the illustration for NetSolutions. In that illustration, supplies were purchased on November 10 (transaction c). The supplies used during November were recorded on November 30 (transaction g). 66124_c03_101-138.qxd 11/10/03 8:07 PM Page 106 106 Chapter 3 • The Matching Concept and the Adjusting Process The balance in NetSolutions’ supplies account on December 31 is $2,000. Some of these supplies (computer diskettes, paper, envelopes, etc.) were used during December, and some are still on hand (not used). If either amount is known, the other can be determined. It is normally easier to determine the cost of the supplies on hand at the end of the month than it is to keep a daily record of those used. Assuming that on December 31 the amount of supplies on hand is $760, the amount to be transferred from the asset account to the expense account is $1,240, computed as follows: Supplies available during December (balance of account) Supplies on hand, December 31 Supplies used (amount of adjustment) $2,000 760 $1,240 As we discussed in Chapter 2, increases in expense accounts are recorded as debits and decreases in asset accounts are recorded as credits. Hence, at the end of December, the supplies expense account should be debited for $1,240, and the supplies account should be credited for $1,240 to record the supplies used during December. The adjusting journal entry and T accounts for Supplies and Supplies Expense are as follows: 2 3 2005 Dec. 31 Supplies Expense Supplies 55 14 Supplies Bal. 760 2,000 Dec. 31 2 1 2 4 0 00 1 2 4 0 00 3 Supplies Expense 1,240 Bal. Dec. 31 800 1,240 2,040 After the adjustment has been recorded and posted, the supplies account has a debit balance of $760. This balance represents an The balance of a prepaid (deferred) asset that will become an expense in a future period. expense is an asset that will become The debit balance of $2,400 in NetSolutions’ prepaid insurance account represents a December 1 prepayment of insurance for 24 an expense in a future period. months. At the end of December, the insurance expense account should be increased (debited), and the prepaid insurance account should be decreased (credited) by $100, the insurance for one month. The adjusting journal entry and T accounts for Prepaid Insurance and Insurance Expense are as follows: 5 6 31 Insurance Expense Prepaid Insurance 56 15 Prepaid Insurance Bal. 2,300 The tuition you pay at the beginning of each term is an example of a deferred expense to you, as a student. 2,400 Dec. 31 1 0 0 00 5 1 0 0 00 6 Insurance Expense 100 Dec. 31 100 After the adjustment has been recorded and posted, the prepaid insurance account has a debit balance of $2,300. This balance represents an asset that will become an expense in future periods. The insurance expense account has a debit balance of $100, which is an expense of the current period. 66124_c03_101-138.qxd 11/10/03 8:07 PM Page 107 Chapter 3 • The Matching Concept and the Adjusting Process 107 What is the effect of omitting adjusting entries? If the preceding adjustments for supplies ($1,240) and insurance ($100) are not recorded, the financial statements prepared as of December 31 will be misstated. On the income statement, Supplies Expense and Insurance Expense will be understated by a total of $1,340, and net income will be overstated by $1,340. On the balance sheet, Supplies and Prepaid Insurance will be overstated by a total of $1,340. Since net income increases owner’s equity, Chris Clark, Capital will also be overstated by $1,340 on the balance sheet. The effects of omitting these adjusting entries on the income statement and balance sheet are shown below. Amount of Misstatement Income Statement Revenues correctly stated Expenses understated by Net income overstated by (1) Balance Sheet Assets overstated by Liabilities correctly stated Owner’s equity overstated by Total liabilities and owner’s equity overstated by Supplies of $1,250 were on hand at the beginning of the period, supplies of $3,800 were purchased during the period, and supplies of $1,000 were on hand at the end of the period. What is the supplies expense for the period? $4,050 ($1,250 ϩ $3,800 Ϫ $1,000) $ XXX (1,340) $1,340 $1,340 (2) $ XXX 1,340 $1,340 Arrow (1) indicates the effect of the understated expenses on assets. Arrow (2) indicates the effect of the overstated net income on owner’s equity. Prepayments of expenses are sometimes made at the beginning of the period in which they will be entirely consumed. On December 1, for example, NetSolutions paid rent of $800 for the month. On December 1, the rent payment represents the asset prepaid rent. The prepaid rent expires daily, and at the end of December, the entire amount has become an expense (rent expense). In cases such as this, the initial payment is recorded as an expense rather than as an asset. Thus, if the payment is recorded as a debit to Rent Expense, no adjusting entry is needed at the end of the period.1 INTEGRITY IN BUSINESS FREE ISSUE O ffice supplies are often available to employees on a “free issue” basis. This means employees do not have to “sign” for the release of office supplies but merely obtain the necessary supplies from a local storage area as needed. Just because supplies are easily available, however, doesn’t mean they can be taken for personal use. There are many instances when employees have been terminated for taking supplies home for personal use. Deferred Revenue (Unearned Revenue) According to NetSolutions’ trial balance on December 31, the balance in the unearned rent account is $360. This balance represents the receipt of three months’ rent on December 1 for December, January, and February. At the end of December, the unearned rent account should be decreased (debited) by $120, and the rent 1This alternative treatment of recording the cost of supplies, rent, and other prepayments of expenses is discussed in Appendix B. 66124_c03_101-138.qxd 11/10/03 8:07 PM Page 108 108 Chapter 3 • The Matching Concept and the Adjusting Process revenue account should be increased (credited) by $120. The $120 represents the rental revenue for one month ($360/3). The adjusting journal entry and T accounts are shown below. 31 Unearned Rent Rent Revenue 8 9 23 42 Unearned Rent Dec. 31 Sears, Roebuck and Co. sells extended warranty contracts with terms between 12 and 36 months. The receipts from sales of these contracts are reported as unearned revenue (deferred revenue) on Sears’ balance sheet. Revenue is recorded as the contracts expire. 120 Bal. 240 1 2 0 00 8 1 2 0 00 9 Rent Revenue 360 Dec. 31 120 After the adjustment has been recorded and posted, the unearned rent account, which is a liability, has a credit balance of $240. This amount represents a deferral that will become revenue in a future period. The rent revenue account has a balance of $120, which is revenue of the current period.2 If the preceding adjustment of unearned rent and rent revenue is not recorded, the financial statements prepared on December 31 will be misstated. On the income statement, Rent Revenue and the net income will be understated by $120. On the balance sheet, Unearned Rent will be overstated by $120, and Chris Clark, Capital will be understated by $120. The effects of omitting this adjusting entry are shown below. Amount of Misstatement Income Statement Revenues understated by Expenses correctly stated Net income understated by Revenues would have been overstated by $60; net income would have been overstated by $60; liabilities would have been understated by $60; and owner’s equity would have been overstated by $60. $(120) XXX $(120) Balance Sheet Assets correctly stated If NetSolutions’ adjustment for unearned rent had incorrectly been made for $180 instead of $120, what would have been the effect on the financial statements? $XXX Liabilities overstated by Owner’s equity understated by Total liabilities and owner’s equity correctly stated $ 120 (120) $XXX Accrued Expenses (Accrued Liabilities) Callaway Golf Company, a manufacturer of such innovative golf clubs as the “Big Bertha” driver, reports accrued warranty expense on its balance sheet. Some types of services, such as insurance, are normally paid for before they are used. These prepayments are deferrals. Other types of services are paid for after the service has been performed. For example, wages expense accumulates or accrues hour by hour and day by day, but payment may be made only weekly, biweekly, or monthly. The amount of such an accrued but unpaid item at the end of the accounting period is both an expense and a liability. In the case of wages expense, if the last day of a pay period is not the last day of the accounting period, the accrued wages expense and the related liability must be recorded in the accounts by an adjusting entry. This adjusting entry is necessary so that expenses are properly matched to the period in which they were incurred. At the end of December, accrued wages for NetSolutions were $250. This amount is an additional expense of December and is debited to the wages expense account. It is also a liability as of December 31 and is credited to Wages Payable. The adjusting journal entry and T accounts are as follows. 2An alternative treatment of recording revenues received in advance of their being earned is discussed in Appendix B. 66124_c03_101-138.qxd 11/10/03 8:07 PM Page 109 Chapter 3 • The Matching Concept and the Adjusting Process 11 12 31 Wages Expense Wages Payable 51 22 Wages Expense Bal. Dec. 31 11 2 5 0 00 2 5 0 00 12 Wages Payable 4,275 250 Dec. 31 4,525 FINANCIAL REPORTING AND DISCLOSURE UNEARNED REVENUE M icrosoft Corporation develops, manufactures, li- censes, and supports a wide range of computer software products, including Windows XP®, Windows NT®, Word®, Excel®, and the Xbox®. When Microsoft sells its products, it incurs an obligation to support its software with technical support and periodic updates. As a result, not all the revenue from selling software is earned on the date of sale. Instead, some of the revenue is unearned. That is, the portion of revenue related to support services, such as updates and technical support, is earned only as time passes and the support services are provided to customers. Thus, it is necessary to make an adjusting entry each year to transfer unearned revenue to revenue. The excerpts below from Microsoft’s 2002 financial statements describe its accounting for unearned revenue. Microsoft further indicated that, of the $7,743 million of unearned revenue at June 30, 2002, it expected to recognize $5,917 million during the next year and $1,826 million in future years. UNEARNED REVENUE . . . Revenue attributable [to] technical support and Internet browser technologies . . . is recognized ratably . . . over the product’s life cycle. The percentage of revenue recognized ratably . . . ranges from approximately 20% to 25% for Windows XP Home, approximately 10% to 15% for Windows XP Professional, and approximately 10% to 15% for desktop applications . . . Product life cycles are currently estimated at three years for Windows operating systems and 18 months for desktop applications. The unearned revenue as of June 30, 2002, was as follows: In Millions June 30 Unearned revenue 2001 2002 $5,614 $7,743 Unearned revenue by product was as follows: In Millions June 30 Desktop applications Desktop platforms Enterprise software and services Desktop and enterprise software and services Consumer software, services, and devices, and other Unearned revenue 109 2001 2002 $2,189 2,586 391 5,166 448 $5,614 $3,489 3,198 791 7,478 265 $7,743 250 66124_c03_101-138.qxd 11/10/03 8:07 PM Page 110 110 Chapter 3 • The Matching Concept and the Adjusting Process I’m 165 years old and came to life as a small family-run soap and candle company in Cincinnati. My celestial logo dates back to the 1850s. I recorded $1 million in annual sales in 1859 and take in around $40 billion annually now. I sell more than 250 items in 130 nations to more than five billion consumers. My Cheer-y and Joyous customers shout Olay! They’ve a Zest for my Bounty, which Cascades over their Head and Shoulders and Pampers them. It’s no Secret that they Sure have a Gleam in their eyes and a Bounce in their step, Always. Who am I? (Go to page 123 for answer.) •Exhibit 4 After the adjustment has been recorded and posted, the debit balance of the wages expense account is $4,525, which is the wages expense for the two months, November and December. The credit balance of $250 in Wages Payable is the amount of the liability for wages owed as of December 31. The accrual of the wages expense for NetSolutions is summarized in Exhibit 4. Note that NetSolutions paid wages of $950 on December 13 and $1,200 on December 27. These payments covered the biweekly pay periods that ended on those days. The wages of $250 incurred for Monday and Tuesday, December 30 and 31, are accrued at December 31. The wages paid on January 10 totaled $1,275, which included the $250 accrued wages of December 31. Accrued Wages 1. Wages are paid on the second and fourth Fridays for the two-week periods ending on those Fridays. The payments were $950 on December 13 and $1,200 on December 27. 2. The wages accrued for Monday and Tuesday, December 30 and 31, are $250. 3. Wages paid on Friday, January 10, total $1,275. December S T W T F S 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 1 Wages expense (accrued), $250 M 2 3 4 8 9 10 11 Wages expense (paid), $950 Wages expense (paid), $1,200 January Wages expense (paid), $1,275 5 6 7 What would be the effect on the financial statements if the adjustment for wages ($250) is not recorded? On the income statement, Wages Expense will be understated by $250, and the net income will be overstated by $250. On the balance sheet, Wages Payable will be understated by $250, and Chris Clark, Capital will be overstated by $250. The effects of omitting this adjusting entry are shown as follows. 66124_c03_101-138.qxd 11/10/03 8:07 PM Page 111 Chapter 3 • The Matching Concept and the Adjusting Process 111 Amount of Misstatement Income Statement Revenues correctly stated Expenses understated by Net income overstated by Balance Sheet Assets correctly stated Assume that weekly wages of $1,500 are paid on Fridays. If wages are incurred evenly throughout the week, what is the accrued wages payable if the accounting period ends on a Tuesday? $XXX (250) $ 250 $XXX Liabilities understated by Owner’s equity overstated by Total liabilities and owner’s equity correctly stated $600 ($1,500/5 ϫ 2 days) $(250) 250 $XXX Accrued Revenues (Accrued Assets) Radio Shack Corporation is engaged in consumer electronics retailing. Radio Shack accrues revenue (accrued receivables) for finance charges, late charges, and returned check fees related to its credit operations. During an accounting period, some revenues are recorded only when cash is received. Thus, at the end of an accounting period, there may be items of revenue that have been earned but have not been recorded. In such cases, the amount of the revenue should be recorded by debiting an asset account and crediting a revenue account. To illustrate, assume that NetSolutions signed an agreement with Dankner Co. on December 15. The agreement provides that NetSolutions will be on call to answer computer questions and render assistance to Dankner Co.’s employees. The services provided will be billed to Dankner Co. on the fifteenth of each month at a rate of $20 per hour. As of December 31, NetSolutions had provided 25 hours of assistance to Dankner Co. Although the revenue of $500 (25 hours ϫ $20) will be billed and collected in January, NetSolutions earned the revenue in December. The adjusting journal entry and T accounts to record the claim against the customer (an account receivable) and the fees earned in December are shown below. 14 15 31 Accounts Receivable Fees Earned Accounts Receivable Bal. Dec. 31 12 41 5 0 0 00 14 5 0 0 00 15 Fees Earned 2,220 500 Bal. Dec. 31 2,720 16,340 500 16,840 If the adjustment for the accrued asset ($500) is not recorded, Fees Earned and the net income will be understated by $500 on the income statement. On the balance sheet, Accounts Receivable and Chris Clark, Capital will be understated by $500. The effects of omitting this adjusting entry are shown below. Amount of Misstatement Income Statement Revenues understated by Expenses correctly stated Net income understated by $(500) XXX $(500) Balance Sheet Assets understated by $(500) Liabilities correctly stated Owner’s equity understated by Total liabilities and owner’s equity understated by $XXX (500) $(500) 66124_c03_101-138.qxd 11/10/03 8:07 PM Page 112 112 Chapter 3 • The Matching Concept and the Adjusting Process Fixed Assets Physical resources that are owned and used by a business and are permanent or have a long life are called fixed assets, or plant assets. In a sense, fixed assets are a type of long-term deferred expense. However, because of their nature and long life, they are discussed separately from other deferred expenses, such as supplies and prepaid insurance. NetSolutions’ fixed assets include office equipment that is used much like supplies are used to generate revenue. Unlike supplies, however, there is no visible reduction in the quantity of the equipment. Instead, as time passes, the equipment loses its ability to provide useful services. This decrease in usefulness is called depreciation. All fixed assets, except land, lose their usefulness. Decreases in the usefulness of assets that are used in generating revenue are recorded as expenses. However, such decreases for fixed assets are difficult to measure. For this reason, a portion of the cost of a fixed asset is recorded as an expense each year of its useful life. This periodic expense is called depreciation expense. Methods of computing depreciation expense are discussed and illustrated in a later chapter. The adjusting entry to record depreciation is similar to the adjusting entry for supplies used. The account debited is a depreciation expense account. However, the asset account Office Equipment is not credited because both the original cost of a fixed asset and the amount of depreciation recorded since its purchase are normally reported on the balance sheet. The account credited is an accumulated depreciation account. Accumulated depreciation accounts are called contra accounts, or contra asset accounts because they are deducted from the related asset accounts on the balance sheet. Normal titles for fixed asset accounts and their related contra asset accounts are as follows: Fixed Asset Contra Asset Land Buildings Store Equipment Office Equipment Lowe’s Companies, Inc. reported land, buildings, and store equipment at a cost of over $12.8 billion and accumulated depreciation of over $2.4 billion. None—Land is not depreciated. Accumulated Depreciation—Buildings Accumulated Depreciation—Store Equipment Accumulated Depreciation—Office Equipment The adjusting entry to record depreciation for December for NetSolutions is illustrated in the following journal entry and T accounts. The estimated amount of depreciation for the month is assumed to be $50. 17 18 19 31 Depreciation Expense Accumulated Depreciation–– Office Equipment 53 18 19 Office Equipment Bal. 17 5 0 00 5 0 00 19 Accumulated Depreciation 1,800 Dec. 31 50 Depreciation Expense Dec. 31 50 The $50 increase in the accumulated depreciation account is subtracted from the $1,800 cost recorded in the related fixed asset account. The difference between the two balances is the $1,750 cost that has not yet been depreciated. This amount ($1,750) is called the book value of the asset (or net book value), which may be presented on the balance sheet in the following manner: 66124_c03_101-138.qxd 11/10/03 8:07 PM Page 113 Chapter 3 • The Matching Concept and the Adjusting Process Office equipment Less accumulated depreciation If equipment cost $5,000 and the related accumulated depreciation is $3,000, what is the book value? $2,000 ($5,000 Ϫ $3,000) $1,800 50 113 $1,750 You should note that the market value of a fixed asset usually differs from its book value. This is because depreciation is an allocation method, not a valuation method. That is, depreciation allocates the cost of a fixed asset to expense over its estimated life. Depreciation does not attempt to measure changes in market values, which may vary significantly from year to year. If the previous adjustment for depreciation ($50) is not recorded, Depreciation Expense on the income statement will be understated by $50, and the net income will be overstated by $50. On the balance sheet, the book value of Office Equipment and Chris Clark, Capital will be overstated by $50. The effects of omitting the adjustment for depreciation are shown below. Amount of Misstatement Income Statement Revenues correctly stated Expenses understated by Net income overstated by $XX (50) $ 50 Balance Sheet Assets overstated by $ 50 Liabilities correctly stated Owner’s equity overstated by Total liabilities and owner’s equity overstated by $XX 50 $ 50 Summary of Adjustment Process We have described and illustrated the basic types of adjusting entries in the preceding section. A summary of these basic adjustments, including the type of adjustment, the adjusting entry, and the effect of omitting an adjustment on the financial stateSummarize the adjustment process and prepare an adments, is shown in Exhibit 5. justed trial balance. The adjusting entries for NetSolutions that we illustrated in this chapter are shown in Exhibit 6. The adjusting entries are dated as of the last day of the period. However, because some time may be needed for collecting the adjustment information, the entries are usually recorded at a later date. Which of the accounts—Fees Earned, Each entry may be supported by an explanation, but a caption above Miscellaneous Expense, Cash, Wages Expense, Supplies, Accounts Receivable, the first adjusting entry is acceptable. Drawing, Equipment, Accumulated These adjusting entries have been posted to the ledger for NetDepreciation—would normally require Solutions, and are shown in color in Exhibit 7 on pages 115–116. an adjusting entry? You should note that in the posting process the Post. Ref. column Fees Earned; Wages Expense; Supplies; Accounts of the journal indicates the account number to which the entry was Receivable; Accumulated Depreciation. posted. The corresponding Post. Ref. column of the account indicates the journal page from which the entry was posted. After all the adjusting entries have been posted, another trial balOne way for an accountant to check ance, called the adjusted trial balance, is prepared. The purpose whether all adjustments have been made is to compare the current of the adjusted trial balance is to verify the equality of the total debit period’s adjustments with those of balances and total credit balances before we prepare the financial the prior period. statements. If the adjusted trial balance does not balance, an error has occurred. However, as we discussed in Chapter 2, errors may have occurred even though the adjusted trial balance totals agree. For example, the adjusted trial balance totals would agree if an adjusting entry has been omitted. objective 4 66124_c03_101-138.qxd 11/10/03 8:07 PM Page 114 114 Chapter 3 • The Matching Concept and the Adjusting Process •Exhibit 5 Type of Adjustment Summary of Basic Adjustments Effect of Omitting Adjusting Entry on the Balance Sheet and Income Statement Adjusting Entry Deferred expense Dr. Expense Cr. Asset Expenses Understated and Net Income Overstated Assets Overstated and Owner’s Equity Overstated Deferred revenue Dr. Liability Cr. Revenue Liabilities Overstated and Owner’s Equity Understated Revenues Understated and Net Income Understated Accrued expense Dr. Expense Cr. Liability Expenses Understated and Net Income Overstated Liabilities Understated and Owner’s Equity Overstated Accrued revenue Dr. Asset Cr. Revenue Assets Understated and Owner’s Equity Understated Revenues Understated and Net Income Understated Fixed assets Dr. Expense Cr. Contra Asset Expenses Understated and Net Income Overstated Assets Overstated and Owner’s Equity Overstated •Exhibit 6 Adjusting Entries—NetSolutions JOURNAL Date Post. Ref. Debit Adjusting Entries 1 2 Description Page 5 2005 Dec. 31 3 1 Supplies Expense Supplies 55 14 1 2 4 0 00 Insurance Expense Prepaid Insurance 56 15 1 0 0 00 Unearned Rent Rent Revenue 23 42 1 2 0 00 Wages Expense Wages Payable 51 22 2 5 0 00 Accounts Receivable Fees Earned 12 41 5 0 0 00 Depreciation Expense Accumulated Depreciation— Office Equipment 53 5 0 00 4 31 6 7 31 9 10 31 12 13 31 15 18 19 14 5 0 0 00 15 16 17 11 2 5 0 00 12 13 14 8 1 2 0 00 9 10 11 5 1 0 0 00 6 7 8 2 1 2 4 0 00 3 4 5 Credit 16 31 17 18 19 5 0 00 19 66124_c03_101-138.qxd 11/10/03 8:07 PM Page 115 115 Chapter 3 • The Matching Concept and the Adjusting Process •Exhibit 7 Ledger with Adjusting Entries—NetSolutions ACCOUNT NO. 11 ACCOUNT Cash Date Item 2005 Balance Post. Ref. Debit Credit Debit Credit 1 1 1 1 1 2 2 2 2 2 2 3 3 3 3 3 3 3 4 4 4 Nov. 1 5 18 30 30 30 Dec. 1 1 1 6 11 13 16 20 21 23 27 31 31 31 31 25,000 20,000 7,500 3,650 950 2,000 2,400 800 360 180 400 950 3,100 900 650 1,450 1,200 310 225 2,870 2,000 ACCOUNT Accounts Receivable Date Item 2005 Dec. 16 21 31 31 Adjusting Item 2005 Nov. 10 30 Dec. 23 31 Adjusting ACCOUNT NO. 12 Balance Post. Ref. Debit Credit Debit Credit 3 3 4 5 1,750 650 1,120 500 1,750 1,100 2,220 2,720 ACCOUNT NO. 14 ACCOUNT Supplies Date 25,000 5,000 12,500 8,850 7,900 5,900 3,500 2,700 3,060 2,880 2,480 1,530 4,630 3,730 4,380 2,930 1,730 1,420 1,195 4,065 2,065 Balance Post. Ref. Debit Credit Debit Credit 1 1 3 5 1,350 800 1,450 1,240 1,350 550 2,000 760 Date Item 2005 Date Item 2005 Dec. 1 31 Adjusting Balance Post. Ref. Debit Credit Debit Credit 2 5 2,400 100 2,400 2,300 20,000 ACCOUNT Office Equipment Date Item 2005 ACCOUNT Date 2005 Dec. 31 Adjusting Item 2005 Balance Post. Ref. Debit Credit Debit Credit 50 5 2005 Dec. 31 Item Adjusting 1,350 Item 2005 Dec. 1 31 Adjusting 1,800 ACCOUNT NO. 22 Balance Post. Ref. Debit Credit Debit Credit 250 5 Item Balance Post. Ref. Debit Credit Debit Credit 2 5 360 2005 Nov. 30 Dec. 31 ACCOUNT NO. 31 Balance Post. Ref. Debit Credit Debit Credit 25,000 1 Item 360 240 120 ACCOUNT Chris Clark, Drawing Date 250 ACCOUNT NO. 23 ACCOUNT Chris Clark, Capital Date 1,350 400 2,200 1,800 900 400 900 ACCOUNT Unearned Rent Date ACCOUNT NO. 21 950 ACCOUNT Wages Payable Date 50 Balance Post. Ref. Debit Credit Debit Credit 1 1 2 2 3 Nov. 10 30 Dec. 4 11 20 1,800 ACCOUNT NO. 19 ACCOUNT Accounts Payable Date ACCOUNT NO. 18 1,800 Accumulated Depreciation Item 20,000 Balance Post. Ref. Debit Credit Debit Credit 2 Dec. 4 Nov. 1 ACCOUNT NO. 15 Balance Post. Ref. Debit Credit Debit Credit 1 Nov. 5 2005 ACCOUNT Prepaid Insurance ACCOUNT NO. 17 ACCOUNT Land 25,000 ACCOUNT NO. 32 Balance Post. Ref. Debit Credit Debit Credit 2 4 2,000 2,000 2,000 4,000 66124_c03_101-138.qxd 11/10/03 8:08 PM Page 116 116 Chapter 3 • The Matching Concept and the Adjusting Process •Exhibit 7 (concluded) ACCOUNT NO. 41 ACCOUNT Fees Earned Date Item 2005 Nov. 18 Dec. 16 16 31 31 31 Adjusting Balance Post. Ref. Debit Credit Debit Credit 7,500 3,100 1,750 2,870 1,120 500 1 3 3 4 4 5 ACCOUNT NO. 42 ACCOUNT Rent Revenue Date 2005 Dec. 31 Item Adjusting 7,500 10,600 12,350 15,220 16,340 16,840 Balance Post. Ref. Debit Credit Debit Credit 120 5 Balance Date Item 2005 Nov. 30 Dec. 13 27 31 Adjusting Post. Ref. Debit Credit Debit Credit 1 3 3 5 2,125 950 1,200 250 Date 2005 Nov. 30 Dec. 1 Item 2,125 3,075 4,275 4,525 ACCOUNT NO. 52 ACCOUNT Rent Expense Balance Post. Ref. Debit Credit Debit Credit 1 2 800 800 Date Item 2005 Dec. 31 Adjusting Date Item 2005 Date Item 2005 Nov. 30 Dec. 31 Adjusting Balance Post. Ref. Debit Credit Debit Credit 450 310 225 Item 2005 Dec. 31 Adjusting Balance Post. Ref. Debit Credit Debit Credit 1 5 800 1,240 Nov. 30 Dec. 6 Item 800 2,040 ACCOUNT NO. 56 Balance Post. Ref. Debit Credit Debit Credit 5 100 ACCOUNT Miscellaneous Expense Date 450 760 985 ACCOUNT NO. 55 ACCOUNT Insurance Expense Date 50 ACCOUNT NO. 54 ACCOUNT Supplies Expense 2005 800 1,600 50 5 1 3 4 Nov. 30 Dec. 31 31 ACCOUNT NO. 53 Balance Post. Ref. Debit Credit Debit Credit ACCOUNT Utilities Expense 120 ACCOUNT NO. 51 ACCOUNT Wages Expense ACCOUNT Depreciation Expense 100 ACCOUNT NO. 59 Balance Post. Ref. Debit Credit Debit Credit 1 2 275 180 275 455 To highlight the effect of the adjustments on the accounts, Exhibit 8 shows the unadjusted trial balance, the accounts affected by the adjustments, and the adjusted trial balance. In Chapter 4, we discuss how financial statements, including a classified balance sheet, can be prepared from an adjusted trial balance. We also discuss the use of a work sheet as an aid to summarize the data for preparing adjusting entries and financial statements. 66124_c03_101-138.qxd 11/10/03 8:08 PM Page 117 117 Chapter 3 • The Matching Concept and the Adjusting Process •Exhibit 8 Trial Balances NetSolutions Unadjusted Trial Balance December 31, 2005 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 Cash Accounts Receivable Supplies Prepaid Insurance Land Office Equipment Accumulated Depreciation Accounts Payable Wages Payable Unearned Rent Chris Clark, Capital Chris Clark, Drawing Fees Earned Rent Revenue Wages Expense Rent Expense Depreciation Expense Utilities Expense Supplies Expense Insurance Expense Miscellaneous Expense 22 2,065 2,220 2,000 2,400 20,000 1,800 1 1 2 3 4 ؉ 500 ؊1,240 ؊ 100 6 360 10 25,000 11 ؉ 50 14 15 ؉ 250 ؊ 120 20 10 12 ؉ 500 ؉ 120 ؉ 250 13 14 15 16 ؉ 50 17 18 18 19 9 11 16 17 7 8 12 16,340 13 455 42,600 4 6 9 985 800 3 5 900 8 4,275 1,600 2 5 7 4,000 NetSolutions Adjusted Trial Balance December 31, 2005 Effect of Adjusting Entry ؉1,240 ؉ 100 19 20 21 21 42,600 22 Cash Accounts Receivable Supplies Prepaid Insurance Land Office Equipment Accumulated Depreciation Accounts Payable Wages Payable Unearned Rent Chris Clark, Capital Chris Clark, Drawing Fees Earned Rent Revenue Wages Expense Rent Expense Depreciation Expense Utilities Expense Supplies Expense Insurance Expense Miscellaneous Expense 22 2,065 2,720 760 2,300 20,000 1,800 1 2 3 4 5 6 50 900 250 240 25,000 4,000 7 8 9 10 11 12 16,840 13 120 14 4,525 1,600 50 985 2,040 100 455 43,400 15 16 17 18 19 20 21 43,400 22 Financial Analysis and Interpretation objective 5 Use vertical analysis to compare financial statement items with each other and with industry averages. Comparing each item in a current statement with a total amount within that same statement can be useful in highlighting significant relationships within a financial statement. Vertical analysis is the term used to describe such comparisons. In vertical analysis of a balance sheet, each asset item is stated as a percent of the total assets. Each liability and owner’s equity item is stated as a percent of the total liabilities and owner’s equity. In vertical analysis of an income statement, each item is stated as a percent of revenues or fees earned. Vertical analysis may also be prepared for several periods to highlight changes in relationships over time. Vertical analysis of two years of income statements for J. Holmes, Attorney-at-Law, is shown in Exhibit 9. This exhibit indicates both favorable and unfavorable trends affecting the income statement of J. Holmes, Attorney-at-Law. The increase in wages expense of 2% (32% Ϫ 30%) is an unfavorable trend, as is the increase in utilities expense of 0.7% (6.7% Ϫ 6.0%). A favorable trend is the decrease in supplies expense of 0.6% (2.0% Ϫ 1.4%). Rent expense and miscellaneous expense as a percent of fees earned were constant. The net result of these trends was that net income decreased as a percent of fees earned from 52.8% to 50.7%. The analysis of the various percentages shown for J. Holmes, Attorney-at-Law, can be enhanced by comparisons with industry averages published by trade associations and financial information services. Any major differences between industry averages should be investigated. 66124_c03_101-138.qxd 11/10/03 8:08 PM Page 118 118 Chapter 3 • The Matching Concept and the Adjusting Process •Exhibit 9 Vertical Analysis of Income Statements J. Holmes, Attorney-at-Law Income Statements For the Years Ended December 31, 2005 and 2006 2006 2005 Amount Fees earned . . . . . . . . . . . . Operating expenses: Wages expense . . . . . . . . Rent expense . . . . . . . . . . Utilities expense . . . . . . . . Supplies expense . . . . . . . Miscellaneous expense . . . Total operating expenses Net income . . . . . . . . . . . . Percent Amount Percent .. $187,500 100.0% $150,000 100.0% . . . . . . . $ 60,000 15,000 12,500 2,700 2,300 $ 92,500 $ 95,000 32.0% 8.0% 6.7% 1.4% 1.2% 49.3% 50.7% $ 45,000 12,000 9,000 3,000 1,800 $ 70,800 $ 79,200 . . . . . . . 30.0%* 8.0% 6.0% 2.0% 1.2% 47.2% 52.8% *$45,000 Ϭ $150,000 SPOTLIGHT ON STRATEGY NOT CUTTING CORNERS H ave you ever ordered a hamburger from Wendy’s and noticed that the meat patty is square? The square meat patty reflects a business strategy instilled in Wendy’s by its founder, Dave Thomas. Mr. Thomas’s strategy was to offer high-quality products at a fair price in a friendly atmosphere, without “cutting corners”; hence, the square meat patty. In the highly competitive fast-food industry, Dave Thomas’s strategy enabled Wendy’s to grow to be the third largest fast-food restaurant in the world, with annual sales of over $7 billion. Source: “Dave Thomas, 69, Wendy’s Founder, Dies,” by Douglas Martin, The New York Times, January 9, 2002. Key Points 1 Explain how the matching concept relates to the accrual basis of accounting. The accrual basis of accounting requires the use of an adjusting process at the end of the accounting period to match revenues and expenses properly. Revenues are reported in the period in which they are earned, and expenses are matched with the revenues they generate. 2 Explain why adjustments are necessary and list the characteristics of adjusting entries. At the end of an accounting period, some of the amounts listed on the trial balance are not necessarily current balances. For example, amounts listed for prepaid expenses are normally overstated because the use of these assets has not been recorded on a daily basis. A delay in recog- nizing an expense already paid or a revenue already received is called a deferral. Some revenues and expenses related to a period may not be recorded at the end of the period, since these items are normally recorded only when cash has been received or paid. A revenue or expense that has not been paid or recorded is called an accrual. 66124_c03_101-138.qxd 11/10/03 8:08 PM Page 119 Chapter 3 • The Matching Concept and the Adjusting Process The entries required at the end of an accounting period to bring accounts up to date and to ensure the proper matching of revenues and expenses are called adjusting entries. Adjusting entries require a debit or a credit to a revenue or an expense account and an offsetting debit or credit to an asset or a liability account. Adjusting entries affect amounts reported in the income statement and the balance sheet. Thus, if an adjusting entry is not recorded, these financial statements will be incorrect (misstated). 3 Journalize entries for accounts requiring adjustment. Adjusting entries illustrated in this chapter include deferred (prepaid) expenses, deferred (unearned) revenues, accrued expenses (accrued liabilities), and accrued revenues (accrued assets). In addition, the adjusting entry necessary to record depreciation on fixed assets was illustrated. 4 Summarize the adjustment process and prepare an adjusted trial balance. A summary of adjustments, including the type of adjustment, the adjusting entry, and the effect of omitting an adjustment on the financial statements, is shown in Exhibit 5. After all the adjusting entries have been posted, the equality of the total debit balances and total credit balances is verified by an adjusted trial balance. 5 119 Use vertical analysis to compare financial statement items with each other and with industry averages. Comparing each item in a current statement with a total amount within the same statement is called vertical analysis. In vertical analysis of a balance sheet, each asset item is stated as a percent of the total assets. Each liability and owner’s equity item is stated as a percent of the total liabilities and owner’s equity. In vertical analysis of an income statement, each item is stated as a percent of revenues or fees earned. Key Terms accounting period concept (102) accrual basis (102) accruals (103) accrued assets (104) accrued expenses (103) accrued liabilities (103) accrued revenues (104) accumulated depreciation (112) adjusted trial balance (113) adjusting entries (103) adjusting process (103) book value of the asset (112) cash basis (102) contra account (112) deferrals (103) deferred expenses (103) deferred revenues (103) depreciation (112) depreciation expense (112) fixed assets (112) matching concept (102) prepaid expenses (103) revenue recognition concept (102) unearned revenues (103) vertical analysis (116) Illustrative Problem Three years ago, T. Roderick organized Harbor Realty. At July 31, 2006, the end of the current year, the unadjusted trial balance of Harbor Realty appears as shown at the top of the following page. The data needed to determine year-end adjustments are as follows: a. b. c. d. e. f. Supplies on hand at July 31, 2006, 380. Insurance premiums expired during the year, $315. Depreciation of equipment during the year, $4,950. Wages accrued but not paid at July 31, 2006, $440. Accrued fees earned but not recorded at July 31, 2006, $1,000. Unearned fees on July 31, 2006, $750. Instructions 1. Prepare the necessary adjusting journal entries. 2. Determine the balance of the accounts affected by the adjusting entries and prepare an adjusted trial balance. 66124_c03_101-138.qxd 11/10/03 8:08 PM Page 120 120 Chapter 3 • The Matching Concept and the Adjusting Process Harbor Realty Trial Balance July 31, 2006 Cash Accounts Receivable Supplies Prepaid Insurance Office Equipment Accumulated Depreciation Accounts Payable Wages Payable Unearned Fees T. Roderick, Capital T. Roderick, Drawing Fees Earned Wages Expense Depreciation Expense Rent Expense Utilities Expense Supplies Expense Insurance Expense Miscellaneous Expense 3 4 2 5 00 7 0 0 0 00 1 2 7 0 00 6 2 0 00 51 6 5 0 00 9 7 0 0 00 9 2 5 00 0 00 1 2 5 0 00 29 0 0 0 00 5 2 0 0 00 59 1 2 5 00 22 4 1 5 00 0 00 4 2 0 0 00 2 7 1 5 00 0 00 0 00 1 5 0 5 00 100 0 0 0 00 100 0 0 0 00 Solution 1. JOURNAL Date 1 2006 July 31 2 Description Post. Ref. Debit Supplies Expense Supplies 8 9 0 00 Insurance Expense Prepaid Insurance 3 1 5 00 3 31 5 6 31 8 Depreciation Expense Accumulated Depreciation 4 9 5 0 00 9 31 11 Wages Expense Wages Payable 4 4 0 00 12 31 14 Accounts Receivable Fees Earned 1 0 0 0 00 17 13 1 0 0 0 00 14 15 16 10 4 4 0 00 11 12 13 7 4 9 5 0 00 8 9 10 4 3 1 5 00 5 6 7 1 8 9 0 00 2 3 4 Credit 15 31 Unearned Fees Fees Earned 5 0 0 00 16 5 0 0 00 17 66124_c03_101-138.qxd 11/10/03 8:09 PM Page 121 Chapter 3 • The Matching Concept and the Adjusting Process 121 2. Harbor Realty Adjusted Trial Balance July 31, 2006 Cash Accounts Receivable Supplies Prepaid Insurance Office Equipment Accumulated Depreciation Accounts Payable Wages Payable Unearned Fees T. Roderick, Capital T. Roderick, Drawing Fees Earned Wages Expense Depreciation Expense Rent Expense Utilities Expense Supplies Expense Insurance Expense Miscellaneous Expense 3 4 2 5 00 8 0 0 0 00 3 8 0 00 3 0 5 00 51 6 5 0 00 14 6 5 0 00 9 2 5 00 4 4 0 00 7 5 0 00 29 0 0 0 00 5 2 0 0 00 60 6 2 5 00 22 8 5 5 00 4 9 5 0 00 4 2 0 0 00 2 7 1 5 00 8 9 0 00 3 1 5 00 1 5 0 5 00 106 3 9 0 00 Self-Examination Questions 1. Which of the following items represents a deferral? A. Prepaid insurance B. Wages payable C. Fees earned D. Accumulated depreciation 2. If the supplies account, before adjustment on May 31, indicated a balance of $2,250, and supplies on hand at May 31 totaled $950, the adjusting entry would be: A. debit Supplies, $950; credit Supplies Expense, $950. B. debit Supplies, $1,300; credit Supplies Expense, $1,300. C. debit Supplies Expense, $950; credit Supplies, $950. D. debit Supplies Expense, $1,300; credit Supplies, $1,300. 3. The balance in the unearned rent account for Jones Co. as of December 31 is $1,200. If Jones Co. failed to record the adjusting entry for $600 of rent earned 106 3 9 0 00 (Answers at End of Chapter) during December, the effect on the balance sheet and income statement for December is: A. assets understated $600; net income overstated $600. B. liabilities understated $600; net income understated $600. C. liabilities overstated $600; net income understated $600. D. liabilities overstated $600; net income overstated $600. 4. If the estimated amount of depreciation on equipment for a period is $2,000, the adjusting entry to record depreciation would be: A. debit Depreciation Expense, $2,000; credit Equipment, $2,000. B. debit Equipment, $2,000; credit Depreciation Expense, $2,000. C. debit Depreciation Expense, $2,000; credit Accumulated Depreciation, $2,000. D. debit Accumulated Depreciation, $2,000; credit Depreciation Expense, $2,000. 66124_c03_101-138.qxd 11/10/03 8:09 PM Page 122 122 Chapter 3 • The Matching Concept and the Adjusting Process 5. If the equipment account has a balance of $22,500 and its accumulated depreciation account has a balance of $14,000, the book value of the equipment is: A. $36,500. B. $22,500. C. $14,000. D. $8,500. C lass Discussion Questions 1. How are revenues and expenses reported on the income statement under (a) the cash basis of accounting and (b) the accrual basis of accounting? 2. Fees for services provided are billed to a customer during 2005. The customer remits the amount owed in 2006. During which year would the revenues be reported on the income statement under (a) the cash basis? (b) the accrual basis? 3. Employees performed services in 2005, but the wages were not paid until 2006. During which year would the wages expense be reported on the income statement under (a) the cash basis? (b) the accrual basis? 4. Is the matching concept related to (a) the cash basis of accounting or (b) the accrual basis of accounting? 5. Is the balance listed for cash on the trial balance, before the accounts have been adjusted, the amount that should normally be reported on the balance sheet? Explain. 6. Is the balance listed for supplies on the trial balance, before the accounts have been adjusted, the amount that should normally be reported on the balance sheet? Explain. 7. Why are adjusting entries needed at the end of an accounting period? 8. What is the difference between adjusting entries and correcting entries? 9. Identify the five different categories of adjusting entries frequently required at the end of an accounting period. 10. If the effect of the credit portion of an adjusting entry is to increase the balance of a liability account, which of the following statements describes the effect of the debit portion of the entry? a. Increases the balance of a revenue account. b. Increases the balance of an expense account. c. Increases the balance of an asset account. 11. If the effect of the debit portion of an adjusting entry is to increase the balance of an asset account, which of the following statements describes the effect of the credit portion of the entry? a. Increases the balance of a revenue account. b. Increases the balance of an expense account. c. Increases the balance of a liability account. 12. Does every adjusting entry have an effect on determining the amount of net income for a period? Explain. 13. What is the nature of the balance in the prepaid insurance account at the end of the accounting period (a) before adjustment? (b) after adjustment? 14. On August 1 of the current year, a business paid the August rent on the building that it occupies. (a) Do the rights acquired at August 1 represent an asset or an expense? (b) What is the justification for debiting Rent Expense at the time of payment? 15. (a) Explain the purpose of the two accounts: Depreciation Expense and Accumulated Depreciation. (b) What is the normal balance of each account? (c) Is it customary for the balances of the two accounts to be equal in amount? (d) In what financial statements, if any, will each account appear? 66124_c03_101-138.qxd 11/10/03 8:09 PM Page 123 Chapter 3 • The Matching Concept and the Adjusting Process 123 Remember! If you need additional help, visit South-Western’s Web site. See page 28 for a description of the online and printed materials that are available. http://warren.swlearning.com Answer: Procter & Gamble E xercises EXERCISE 3-1 Classify accruals and deferrals Objectives 2, 3 EXERCISE 3-2 Classify adjusting entries Objectives 2, 3 Classify the following items as (a) deferred expense (prepaid expense), (b) deferred revenue (unearned revenue), (c) accrued expense (accrued liability), or (d) accrued revenue (accrued asset). 1. 2. 3. 4. 5. 6. 7. 8. Salary owed but not yet paid. Supplies on hand. Fees received but not yet earned. Fees earned but not yet received. Taxes owed but payable in the following period. Utilities owed but not yet paid. A two-year premium paid on a fire insurance policy. Subscriptions received in advance by a magazine publisher. The following accounts were taken from the unadjusted trial balance of Dobro Co., a congressional lobbying firm. Indicate whether or not each account would normally require an adjusting entry. If the account normally requires an adjusting entry, use the following notation to indicate the type of adjustment: AE—Accrued Expense AR—Accrued Revenue DR—Deferred Revenue DE—Deferred Expense To illustrate, the answers for the first two accounts are shown below. Account Aaron Piper, Drawing . . . Accounts Receivable . . . . Accumulated Depreciation Cash . . . . . . . . . . . . . . . . Interest Payable . . . . . . . . Interest Receivable . . . . . Land . . . . . . . . . . . . . . . . Office Equipment . . . . . . Prepaid Rent . . . . . . . . . . Supplies Expense . . . . . . . Unearned Fees . . . . . . . . Wages Expense . . . . . . . . Answer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Does not normally require adjustment. Normally requires adjustment (AR). 66124_c03_101-138.qxd 11/10/03 8:09 PM Page 124 124 Chapter 3 • The Matching Concept and the Adjusting Process EXERCISE 3-3 Adjusting entry for supplies Objective 3 EXERCISE 3-4 Determine supplies purchased The balance in the supplies account, before adjustment at the end of the year, is $1,175. Journalize the adjusting entry required if the amount of supplies on hand at the end of the year is $374. The supplies and supplies expense accounts at December 31, after adjusting entries have been posted at the end of the first year of operations, are shown in the following T accounts: Objective 3 Supplies Bal. Supplies Expense 118 Bal. 949 Determine the amount of supplies purchased during the year. EXERCISE 3-5 Effect of omitting adjusting entry Objective 3 EXERCISE 3-6 Adjusting entries for prepaid insurance Objective 3 EXERCISE 3-7 Adjusting entries for prepaid insurance Objective 3 EXERCISE 3-8 Adjusting entries for unearned fees At December 31, the end of the first month of operations, the usual adjusting entry transferring prepaid insurance expired to an expense account is omitted. Which items will be incorrectly stated, because of the error, on (a) the income statement for December and (b) the balance sheet as of December 31? Also indicate whether the items in error will be overstated or understated. The balance in the prepaid insurance account, before adjustment at the end of the year, is $2,475. Journalize the adjusting entry required under each of the following alternatives for determining the amount of the adjustment: (a) the amount of insurance expired during the year is $1,215; (b) the amount of unexpired insurance applicable to future periods is $1,260. The prepaid insurance account had a balance of $5,600 at the beginning of the year. The account was debited for $1,800 for premiums on policies purchased during the year. Journalize the adjusting entry required at the end of the year for each of the following situations: (a) the amount of unexpired insurance applicable to future periods is $3,680; (b) the amount of insurance expired during the year is $3,720. The balance in the unearned fees account, before adjustment at the end of the year, is $21,880. Journalize the adjusting entry required if the amount of unearned fees at the end of the year is $12,310. Objective 3 Amount of entry: $9,570 EXERCISE 3-9 Effect of omitting adjusting entry Objective 3 EXERCISE 3-10 Adjusting entries for accrued salaries At the end of July, the first month of the business year, the usual adjusting entry transferring rent earned to a revenue account from the unearned rent account was omitted. Indicate which items will be incorrectly stated, because of the error, on (a) the income statement for July and (b) the balance sheet as of July 31. Also indicate whether the items in error will be overstated or understated. Xenon Realty Co. pays weekly salaries of $15,600 on Friday for a five-day week ending on that day. Journalize the necessary adjusting entry at the end of the accounting period, assuming that the period ends (a) on Wednesday, (b) on Thursday. Objective 3 a. Amount of entry: $9,360 EXERCISE 3-11 Determine wages paid Objective 3 The wages payable and wages expense accounts at August 31, after adjusting entries have been posted at the end of the first month of operations, are shown in the following T accounts: Wages Payable Bal. Wages Expense 3,150 Bal. 63,000 Determine the amount of wages paid during the month. 66124_c03_101-138.qxd 11/10/03 8:09 PM Page 125 125 Chapter 3 • The Matching Concept and the Adjusting Process EXERCISE 3-12 Effect of omitting adjusting entry Objective 3 EXERCISE 3-13 Effect of omitting adjusting entry Objective 3 EXERCISE 3-14 Adjusting entries for prepaid and accrued taxes Objective 3 b. $9,695 EXERCISE 3-15 Effects of errors on financial statements Objective 3 EXERCISE 3-16 Effects of errors on financial statements Objective 3 EXERCISE 3-17 Effects of errors on financial statements Objective 3 1. a. Revenue understated, $6,900 Accrued salaries of $1,590 owed to employees for December 30 and 31 are not considered in preparing the financial statements for the year ended December 31. Indicate which items will be erroneously stated, because of the error, on (a) the income statement for the year and (b) the balance sheet as of December 31. Also indicate whether the items in error will be overstated or understated. Assume that the error in Exercise 3-12 was not corrected and that the $1,590 of accrued salaries was included in the first salary payment in January. Indicate which items will be erroneously stated, because of failure to correct the initial error, on (a) the income statement for the month of January and (b) the balance sheet as of January 31. Titanium Financial Services was organized on April 1 of the current year. On April 2, Titanium prepaid $1,260 to the city for taxes (license fees) for the next 12 months and debited the prepaid taxes account. Titanium is also required to pay in January an annual tax (on property) for the previous calendar year. The estimated amount of the property tax for the current year (April 1 to December 31) is $8,750. (a) Journalize the two adjusting entries required to bring the accounts affected by the two taxes up to date as of December 31, the end of the current year. (b) What is the amount of tax expense for the current year? For a recent period, Circuit City Stores reported accrued expenses and other current liabilities of $128,776,000. For the same period, Circuit City reported earnings of $67,040,000 before income taxes. If accrued expenses and other current liabilities had not been recorded, what would have been the earnings (loss) before income taxes? The balance sheet for The Campbell Soup Co. as of July 31, 2002, includes accrued liabilities of $503,000,000. The income before taxes for The Campbell Soup Co. for the year ended July 28, 2002, was $798,000,000. (a) If the accruals had not been recorded at July 28, 2002, by how much would income before taxes have been misstated for the fiscal year ended July 28, 2002? (b) What is the percentage of the misstatement in (a) to the reported income of $798,000,000? The accountant for Glacier Medical Co., a medical services consulting firm, mistakenly omitted adjusting entries for (a) unearned revenue earned during the year ($6,900) and (b) accrued wages ($3,740). Indicate the effect of each error, considered individually, on the income statement for the current year ended December 31. Also indicate the effect of each error on the December 31 balance sheet. Set up a table similar to the following, and record your answers by inserting the dollar amount in the appropriate spaces. Insert a zero if the error does not affect the item. Error (a) Error (b) Overstated 1. Revenue for the year would be 2. Expenses for the year would be 3. Net income for the year would be Understated Overstated $ $ $ $ $ $ $ $ $ Understated $ $ $ (continued) 66124_c03_101-138.qxd 11/10/03 8:09 PM Page 126 126 Chapter 3 • The Matching Concept and the Adjusting Process Error (a) Error (b) Overstated 4. Assets at December 31 would be 5. Liabilities at December 31 would be 6. Owner’s equity at December 31 would be EXERCISE 3-18 Effects of errors on financial statements Understated Overstated Understated $ $ $ $ $ $ $ $ $ $ $ $ If the net income for the current year had been $172,680 in Exercise 3-17, what would be the correct net income if the proper adjusting entries had been made? Objective 3 EXERCISE 3-19 Adjusting entry for accrued fees At the end of the current year, $11,500 of fees have been earned but have not been billed to clients. Objective 3 a. Journalize the adjusting entry to record the accrued fees. b. If the cash basis rather than the accrual basis had been used, would an adjusting entry have been necessary? Explain. EXERCISE 3-20 The balance in the unearned fees account, before adjustment at the end of the year, is $27,600. Of these fees, $8,100 have been earned. In addition, $6,450 of fees have been earned but have not been billed. Journalize the adjusting entries (a) to adjust the unearned fees account and (b) to record the accrued fees. Adjusting entries for unearned and accrued fees Objective 3 EXERCISE 3-21 Effect on financial statements of omitting adjusting entry Objective 3 EXERCISE 3-22 Adjustment for depreciation The adjusting entry for accrued fees was omitted at December 31, the end of the current year. Indicate which items will be in error, because of the omission, on (a) the income statement for the current year and (b) the balance sheet as of December 31. Also indicate whether the items in error will be overstated or understated. The estimated amount of depreciation on equipment for the current year is $5,200. Journalize the adjusting entry to record the depreciation. Objective 3 EXERCISE 3-23 Determine fixed asset’s book value The balance in the equipment account is $318,500, and the balance in the accumulated depreciation—equipment account is $113,900. Objective 3 a. What is the book value of the equipment? b. Does the balance in the accumulated depreciation account mean that the equipment’s loss of value is $113,900? Explain. EXERCISE 3-24 Microsoft Corporation reported Property, Plant, and Equipment of $5,891 million and Accumulated Depreciation of $3,623 million at June 30, 2002. Book value of fixed assets Objective 3 EXERCISE 3-25 Adjusting entries for depreciation; effect of error Objective 3 a. What was the book value of the fixed assets at June 30, 2002? b. Would the book value of Microsoft Corporation’s fixed assets normally approximate their fair market values? On December 31, a business estimates depreciation on equipment used during the first year of operations to be $7,500. (a) Journalize the adjusting entry required as of December 31. (b) If the adjusting entry in (a) were omitted, which items would be erroneously stated on (1) the income statement for the year and (2) the balance sheet as of December 31? 66124_c03_101-138.qxd 11/10/03 8:09 PM Page 127 127 Chapter 3 • The Matching Concept and the Adjusting Process EXERCISE 3-26 Adjusting entries from trial balances The unadjusted and adjusted trial balances for Aleutian Services Co. on December 31, 2006, are shown below. Aleutian Services Co. Trial Balance December 31, 2006 Objectives 3, 4 Unadjusted Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . Accounts Receivable . . . . . . . . . . . . . . . Supplies . . . . . . . . . . . . . . . . . . . . . . . . Prepaid Insurance . . . . . . . . . . . . . . . . . Land . . . . . . . . . . . . . . . . . . . . . . . . . . Equipment . . . . . . . . . . . . . . . . . . . . . . Accumulated Depreciation—Equipment Accounts Payable . . . . . . . . . . . . . . . . . Wages Payable . . . . . . . . . . . . . . . . . . . Brian Stuart, Capital . . . . . . . . . . . . . . . Brian Stuart, Drawing . . . . . . . . . . . . . . Fees Earned . . . . . . . . . . . . . . . . . . . . . Wages Expense . . . . . . . . . . . . . . . . . . . Rent Expense . . . . . . . . . . . . . . . . . . . . Insurance Expense . . . . . . . . . . . . . . . . Utilities Expense . . . . . . . . . . . . . . . . . . Depreciation Expense . . . . . . . . . . . . . . Supplies Expense . . . . . . . . . . . . . . . . . Miscellaneous Expense . . . . . . . . . . . . . Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Adjusted 16 38 12 20 26 40 16 42 9 12 26 40 8 26 0 92 13 26 1 92 8 8 74 24 8 0 4 0 0 4 200 78 25 8 8 4 5 3 4 210 200 210 Journalize the five entries that adjusted the accounts at December 31, 2006. None of the accounts were affected by more than one adjusting entry. EXERCISE 3-27 Adjusting entries from trial balances Objectives 3, 4 The accountant for Minaret Laundry prepared the following unadjusted and adjusted trial balances. Assume that all balances in the unadjusted trial balance and the amounts of the adjustments are correct. Identify the errors in the accountant’s adjusting entries. Minaret Laundry Trial Balance May 31, 2006 Unadjusted Corrected trial balance totals, $168,450 Cash . . . . . . . . . . . . . . . . Accounts Receivable . . . . Laundry Supplies . . . . . . . Prepaid Insurance* . . . . . Laundry Equipment . . . . . Accumulated Depreciation Accounts Payable . . . . . . Wages Payable . . . . . . . . Troy Jobe, Capital . . . . . . Troy Jobe, Drawing . . . . . Laundry Revenue . . . . . . Wages Expense . . . . . . . . Rent Expense . . . . . . . . . Utilities Expense . . . . . . . Depreciation Expense . . . Laundry Supplies Expense Insurance Expense . . . . . . Miscellaneous Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . *$1,700 of insurance expired during the year. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,500 7,500 1,750 2,825 85,600 Adjusted 2,500 9,500 2,850 1,125 80,000 55,700 4,950 55,700 4,950 850 32,450 32,450 10,000 10,000 66,900 24,500 15,575 8,500 1,250 160,000 160,000 66,900 24,500 15,575 8,500 5,600 1,100 700 1,250 163,200 160,850 66124_c03_101-138.qxd 11/10/03 8:09 PM Page 128 128 Chapter 3 • The Matching Concept and the Adjusting Process EXERCISE 3-28 Vertical analysis of income statement The financial statements for The Home Depot are presented in Appendix E at the end of the text. Objective 5 a. Determine for Home Depot: 1. The amount of the change (in millions) and percent of change in net earnings (net income) for the year ended February 2, 2003. 2. The percentage relationship between net earnings (net income) and net sales (net earnings divided by net sales) for the years ended February 2, 2003 and February 3, 2002. b. What conclusions can you draw from your analysis? EXERCISE 3-29 The following income statement data (in thousands) for Dell Computer Corporation and Gateway Inc. were taken from their recent annual reports: Vertical analysis of income statement Dell Objective 5 Net sales Cost of goods sold (expense) Operating expenses Operating income (loss) Gateway $35,404,000 (29,055,000) (3,505,000) $ 2,844,000 $ 4,171,325 (3,605,120) (1,077,447) $ (511,242) a. Prepare a vertical analysis of the income statement for Dell. b. Prepare a vertical analysis of the income statement for Gateway. c. Based upon (a) and (b), how does Dell compare to Gateway? Problems Series A PROBLEM 3-1A Adjusting entries Objective 3 On August 31, 2006, the following data were accumulated to assist the accountant in preparing the adjusting entries for Osage Realty: a. Fees accrued but unbilled at August 31 are $7,100. b. The supplies account balance on August 31 is $3,010. The supplies on hand at August 31 are $1,150. c. Wages accrued but not paid at August 31 are $1,380. d. The unearned rent account balance at August 31 is $4,950, representing the receipt of an advance payment on August 1 of three months’ rent from tenants. e. Depreciation of office equipment is $1,120. Instructions 1. Journalize the adjusting entries required at August 31, 2006. 2. Briefly explain the difference between adjusting entries and entries that would be made to correct errors. PROBLEM 3-2A Adjusting entries Selected account balances before adjustment for Flanders Realty at March 31, 2006, the end of the current year, are as follows: Objective 3 Debits Accounts Receivable Supplies Prepaid Rent Equipment Accumulated Depreciation Wages Payable Credits $28,250 1,770 15,500 80,500 $16,900 — Debits Unearned Fees Fees Earned Wages Expense Rent Expense Depreciation Expense Supplies Expense Credits $ 4,800 170,850 $69,750 — — — 66124_c03_101-138.qxd 11/10/03 8:09 PM Page 129 Chapter 3 • The Matching Concept and the Adjusting Process 129 Data needed for year-end adjustments are as follows: a. b. c. d. e. f. Supplies on hand at March 31, $350. Depreciation of equipment during year, $1,450. Rent expired during year, $9,500. Wages accrued but not paid at March 31, $1,050. Unearned fees at March 31, $1,200. Unbilled fees at March 31, $7,100. Instructions Journalize the six adjusting entries required at March 31, based upon the data presented. PROBLEM 3-3A Adjusting entries Wild Trout Co., an outfitter store for fishing treks, prepared the following trial balance at the end of its first year of operations: Objective 3 Wild Trout Co. Trial Balance November 30, 2006 Cash . . . . . . . . . . . . . . Accounts Receivable . . Supplies . . . . . . . . . . . . Equipment . . . . . . . . . . Accounts Payable . . . . . Unearned Fees . . . . . . . Angie Sanders, Capital . Angie Sanders, Drawing Fees Earned . . . . . . . . . Wages Expense . . . . . . Rent Expense . . . . . . . . Utilities Expense . . . . . Miscellaneous Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,610 11,900 1,820 27,860 1,050 2,800 37,800 1,400 51,450 28,210 13,790 5,250 1,260 93,100 93,100 For preparing the adjusting entries, the following data were assembled: a. b. c. d. e. Supplies on hand on November 30 were $315. Fees earned but unbilled on November 30 were $1,750. Depreciation of equipment was estimated to be $1,600 for the year. Unpaid wages accrued on November 30 were $380. The balance in unearned fees represented the November 1 receipt in advance for services to be provided. Only $700 of the services were provided between November 1 and November 30. Instructions Journalize the adjusting entries necessary on November 30. PROBLEM 3-4A Adjusting entries Objectives 3, 4 Dynamo Company specializes in the maintenance and repair of signs, such as billboards. On March 31, 2006, the accountant for Dynamo Company prepared the trial balances shown at the top of the next page. Instructions Journalize the seven entries that adjusted the accounts at March 31. None of the accounts were affected by more than one adjusting entry. (continued) 66124_c03_101-138.qxd 11/10/03 8:09 PM Page 130 130 Chapter 3 • The Matching Concept and the Adjusting Process Dynamo Company Trial Balance March 31, 2006 Unadjusted Cash . . . . . . . . . . . . . . . . . . . . . . . . . Accounts Receivable . . . . . . . . . . . . . Supplies . . . . . . . . . . . . . . . . . . . . . . Prepaid Insurance . . . . . . . . . . . . . . . Land . . . . . . . . . . . . . . . . . . . . . . . . . Buildings . . . . . . . . . . . . . . . . . . . . . Accumulated Depreciation—Buildings Trucks . . . . . . . . . . . . . . . . . . . . . . . . Accumulated Depreciation—Trucks . . Accounts Payable . . . . . . . . . . . . . . . Salaries Payable . . . . . . . . . . . . . . . . Unearned Service Fees . . . . . . . . . . . Joy Autry, Capital . . . . . . . . . . . . . . . Joy Autry, Drawing . . . . . . . . . . . . . . Service Fees Earned . . . . . . . . . . . . . . Salary Expense . . . . . . . . . . . . . . . . . Depreciation Expense—Trucks . . . . . . Rent Expense . . . . . . . . . . . . . . . . . . Supplies Expense . . . . . . . . . . . . . . . . Utilities Expense . . . . . . . . . . . . . . . . Depreciation Expense—Buildings . . . . Taxes Expense . . . . . . . . . . . . . . . . . . Insurance Expense . . . . . . . . . . . . . . . Miscellaneous Expense . . . . . . . . . . . PROBLEM 3-5A Adjusting entries and adjusted trial balances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Adjusted 4,750 17,400 3,880 4,800 47,500 111,590 4,750 17,400 1,175 3,200 47,500 111,590 56,600 60,700 73,000 73,000 11,800 6,920 — 6,400 125,600 20,300 7,435 1,080 4,750 125,600 5,000 5,000 152,680 73,600 — 9,600 — 6,200 — 1,720 — 960 360,000 154,330 74,680 8,500 9,600 2,705 6,715 4,100 1,720 1,600 960 374,195 360,000 374,195 Greco Service Co., which specializes in appliance repair services, is owned and operated by Curtis Loomis. Greco Service Co.’s accounting clerk prepared the following trial balance at December 31, 2006: Objectives 3, 4 Greco Service Co. Trial Balance December 31, 2006 2. Total of Debit Column: $552,520 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . Accounts Receivable . . . . . . . . . . . . . . . Prepaid Insurance . . . . . . . . . . . . . . . . . Supplies . . . . . . . . . . . . . . . . . . . . . . . . Land . . . . . . . . . . . . . . . . . . . . . . . . . . Building . . . . . . . . . . . . . . . . . . . . . . . . Accumulated Depreciation—Building . . Equipment . . . . . . . . . . . . . . . . . . . . . . Accumulated Depreciation—Equipment Accounts Payable . . . . . . . . . . . . . . . . . Unearned Rent . . . . . . . . . . . . . . . . . . Curtis Loomis, Capital . . . . . . . . . . . . . . Curtis Loomis, Drawing . . . . . . . . . . . . Fees Earned . . . . . . . . . . . . . . . . . . . . . Salaries and Wages Expense . . . . . . . . . Utilities Expense . . . . . . . . . . . . . . . . . . Advertising Expense . . . . . . . . . . . . . . . Repairs Expense . . . . . . . . . . . . . . . . . . Miscellaneous Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,200 20,600 6,000 1,450 100,000 161,500 75,700 80,100 35,300 7,500 7,200 157,100 5,000 257,200 101,800 28,200 15,000 12,100 4,050 540,000 The data needed to determine year-end adjustments are as follows: a. Depreciation of building for the year, $3,600. b. Depreciation of equipment for the year, $2,400. c. Accrued salaries and wages at December 31, $2,170. 540,000 66124_c03_101-138.qxd 11/10/03 8:09 PM Page 131 Chapter 3 • The Matching Concept and the Adjusting Process d. e. f. g. 131 Unexpired insurance at December 31, $3,500. Fees earned but unbilled on December 31, $4,350. Supplies on hand at December 31, $375. Rent unearned at December 31, $2,800. Instructions 1. Journalize the adjusting entries. Add additional accounts as needed. 2. Determine the balances of the accounts affected by the adjusting entries and prepare an adjusted trial balance. PROBLEM 3-6A Adjusting entries and errors At the end of July, the first month of operations, the following selected data were taken from the financial statements of Kay Lopez, an attorney: Objective 3 Corrected Net Income: $127,900 Net income for July Total assets at July 31 Total liabilities at July 31 Total owner’s equity at July 31 $124,350 500,000 125,000 375,000 In preparing the financial statements, adjustments for the following data were overlooked: a. b. c. d. Unbilled fees earned at July 31, $9,600. Depreciation of equipment for July, $3,500. Accrued wages at July 31, $1,450. Supplies used during July, $1,100. Instructions 1. Journalize the entries to record the omitted adjustments. 2. Determine the correct amount of net income for July and the total assets, liabilities, and owner’s equity at July 31. In addition to indicating the corrected amounts, indicate the effect of each omitted adjustment by setting up and completing a columnar table similar to the following. Adjustment (a) is presented as an example. Net Income Reported amounts Corrections: Adjustment (a) Adjustment (b) Adjustment (c) Adjustment (d) Corrected amounts Total Assets Total Liabilities Total Owner’s Equity $124,350 $500,000 $125,000 $375,000 ϩ9,600 ϩ9,600 0 ϩ9,600 Problems Series B PROBLEM 3-1B Adjusting entries Objective 3 On October 31, 2006, the following data were accumulated to assist the accountant in preparing the adjusting entries for Melville Realty: a. The supplies account balance on October 31 is $1,875. The supplies on hand on October 31 are $310. b. The unearned rent account balance on October 31 is $4,020, representing the receipt of an advance payment on October 1 of three months’ rent from tenants. c. Wages accrued but not paid at October 31 are $2,150. d. Fees accrued but unbilled at October 31 are $11,278. e. Depreciation of office equipment is $1,000. 66124_c03_101-138.qxd 11/10/03 8:09 PM Page 132 132 Chapter 3 • The Matching Concept and the Adjusting Process Instructions 1. Journalize the adjusting entries required at October 31, 2006. 2. Briefly explain the difference between adjusting entries and entries that would be made to correct errors. PROBLEM 3-2B Adjusting entries Selected account balances before adjustment for Maltese Realty at May 31, 2006, the end of the current year, are as follows: Objective 3 Debits Accounts Receivable Supplies Prepaid Rent Equipment Accumulated Depreciation Wages Payable Credits Debits $11,250 1,750 7,500 52,500 Unearned Fees Fees Earned Wages Expense Rent Expense Depreciation Expense Supplies Expense $8,900 — Credits $ 6,500 117,950 $59,400 — — — Data needed for year-end adjustments are as follows: a. b. c. d. e. f. Unbilled fees at May 31, $1,150. Supplies on hand at May 31, $360. Rent expired $6,000. Depreciation of equipment during year, $1,650. Unearned fees at May 31, $1,775. Wages accrued but not paid at May 31, $2,180. Instructions Journalize the six adjusting entries required at May 31, based upon the data presented. PROBLEM 3-3B Adjusting entries Anguilla Company, an electronics repair store, prepared the following trial balance at the end of its first year of operations: Objective 3 Anguilla Company Trial Balance April 30, 2006 Cash . . . . . . . . . . . . . Accounts Receivable . . Supplies . . . . . . . . . . . Equipment . . . . . . . . . Accounts Payable . . . . Unearned Fees . . . . . . Oscar Daly, Capital . . . Oscar Daly, Drawing . . Fees Earned . . . . . . . . Wages Expense . . . . . Rent Expense . . . . . . . Utilities Expense . . . . . Miscellaneous Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,300 15,000 3,600 75,800 3,500 4,000 52,000 3,000 90,500 21,000 16,000 11,500 1,800 150,000 150,000 For preparing the adjusting entries, the following data were assembled: a. b. c. d. Fees earned but unbilled on April 30 were $3,200. Supplies on hand on April 30 were $1,010. Depreciation of equipment was estimated to be $3,850 for the year. The balance in unearned fees represented the April 1 receipt in advance for services to be provided. Only $1,000 of the services was provided between April 1 and April 30. e. Unpaid wages accrued on April 30 were $820. Instructions Journalize the adjusting entries necessary on April 30, 2006. 66124_c03_101-138.qxd 11/10/03 8:09 PM Page 133 133 Chapter 3 • The Matching Concept and the Adjusting Process PROBLEM 3-4B Adjusting entries Objectives 3, 4 ExposeЈ Company specializes in the repair of music equipment and is owned and operated by Gavin Staub. On June 30, 2006, the end of the current year, the accountant for ExposeЈ Company prepared the following trial balances: Expose؅ Company Trial Balance June 30, 2006 Unadjusted Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . Accounts Receivable . . . . . . . . . . . . . . . Supplies . . . . . . . . . . . . . . . . . . . . . . . . Prepaid Insurance . . . . . . . . . . . . . . . . . Equipment . . . . . . . . . . . . . . . . . . . . . . Accumulated Depreciation—Equipment . Automobiles . . . . . . . . . . . . . . . . . . . . . Accumulated Depreciation—Automobiles Accounts Payable . . . . . . . . . . . . . . . . . Salaries Payable . . . . . . . . . . . . . . . . . . . Unearned Service Fees . . . . . . . . . . . . . . Gavin Staub, Capital . . . . . . . . . . . . . . . Gavin Staub, Drawing . . . . . . . . . . . . . . Service Fees Earned . . . . . . . . . . . . . . . . Salary Expense . . . . . . . . . . . . . . . . . . . Rent Expense . . . . . . . . . . . . . . . . . . . . Supplies Expense . . . . . . . . . . . . . . . . . . Depreciation Expense—Equipment . . . . . Depreciation Expense—Automobiles . . . Utilities Expense . . . . . . . . . . . . . . . . . . Taxes Expense . . . . . . . . . . . . . . . . . . . . Insurance Expense . . . . . . . . . . . . . . . . . Miscellaneous Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,315 30,500 3,750 4,750 92,150 Adjusted 8,315 30,500 1,080 2,200 92,150 33,480 36,500 40,500 36,500 18,250 8,310 — 6,000 69,360 5,000 21,900 8,730 1,560 4,000 69,360 5,000 244,600 172,300 18,000 — — — 4,300 2,725 — 1,710 380,000 380,000 246,600 173,860 18,000 2,670 7,020 3,650 4,720 2,725 2,550 1,710 392,650 392,650 Instructions Journalize the seven entries that adjusted the accounts at June 30. None of the accounts were affected by more than one adjusting entry. PROBLEM 3-5B Objectives 3, 4 Berserk Company is a small editorial services company owned and operated by Ethel Pringle. On December 31, 2006, the end of the current year, Berserk Company’s accounting clerk prepared the trial balance shown at the top of the next page. The data needed to determine year-end adjustments are as follows: 2. Total of Debit Column: $510,380 a. b. c. d. e. f. g. Adjusting entries and adjusted trial balances Unexpired insurance at December 31, $1,600. Supplies on hand at December 31, $280. Depreciation of building for the year, $1,320. Depreciation of equipment for the year, $4,100. Rent unearned at December 31, $1,500. Accrued salaries and wages at December 31, $1,760. Fees earned but unbilled on December 31, $3,200. Instructions 1. Journalize the adjusting entries. Add additional accounts as needed. 2. Determine the balances of the accounts affected by the adjusting entries and prepare an adjusted trial balance. (continued) 66124_c03_101-138.qxd 11/10/03 8:09 PM Page 134 134 Chapter 3 • The Matching Concept and the Adjusting Process Berserk Company Trial Balance December 31, 2006 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . Accounts Receivable . . . . . . . . . . . . . . . Prepaid Insurance . . . . . . . . . . . . . . . . . Supplies . . . . . . . . . . . . . . . . . . . . . . . . Land . . . . . . . . . . . . . . . . . . . . . . . . . . Building . . . . . . . . . . . . . . . . . . . . . . . . Accumulated Depreciation—Building . . Equipment . . . . . . . . . . . . . . . . . . . . . . Accumulated Depreciation—Equipment Accounts Payable . . . . . . . . . . . . . . . . . Unearned Rent . . . . . . . . . . . . . . . . . . Ethel Pringle, Capital . . . . . . . . . . . . . . Ethel Pringle, Drawing . . . . . . . . . . . . . Fees Earned . . . . . . . . . . . . . . . . . . . . . Salaries and Wages Expense . . . . . . . . . Utilities Expense . . . . . . . . . . . . . . . . . . Advertising Expense . . . . . . . . . . . . . . . Repairs Expense . . . . . . . . . . . . . . . . . . Miscellaneous Expense . . . . . . . . . . . . . PROBLEM 3-6B Adjusting entries and errors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,700 18,900 4,800 1,320 75,000 141,500 91,700 90,200 65,300 8,100 4,500 134,000 10,000 196,400 95,580 28,250 15,200 11,500 4,050 500,000 500,000 At the end of November, the first month of operations, the following selected data were taken from the financial statements of Jaime McCune, an attorney: Objective 3 Corrected Net Income: $209,745 . . . . . . . . . . . . . . . . . . . Net income for November Total assets at November 30 Total liabilities at November 30 Total owner’s equity at November 30 $207,320 440,960 29,720 411,240 In preparing the financial statements, adjustments for the following data were overlooked: a. b. c. d. Supplies used during November, $1,025. Unbilled fees earned at November 30, $7,650. Depreciation of equipment for November, $3,100. Accrued wages at November 30, $1,100. Instructions 1. Journalize the entries to record the omitted adjustments. 2. Determine the correct amount of net income for November and the total assets, liabilities, and owner’s equity at November 30. In addition to indicating the corrected amounts, indicate the effect of each omitted adjustment by setting up and completing a columnar table similar to the following. Adjustment (a) is presented as an example. Net Income Reported amounts Corrections: Adjustment (a) Adjustment (b) Adjustment (c) Adjustment (d) Corrected amounts Total Assets Total Liabilities Total Owner’s Equity $207,320 $440,960 $29,720 $411,240 Ϫ1,025 Ϫ1,025 0 Ϫ1,025 66124_c03_101-138.qxd 11/10/03 8:09 PM Page 135 Chapter 3 • The Matching Concept and the Adjusting Process 135 C ontinuing Problem The trial balance that you prepared for Dancin Music at the end of Chapter 2 should appear as follows: Dancin Music Trial Balance May 31, 2006 3. Total of Debit Column: $33,190 Cash . . . . . . . . . . . . . . . Accounts Receivable . . . Supplies . . . . . . . . . . . . . Prepaid Insurance . . . . . Office Equipment . . . . . Accounts Payable . . . . . . Unearned Revenue . . . . Shannon Burns, Capital . Shannon Burns, Drawing Fees Earned . . . . . . . . . . Wages Expense . . . . . . . Office Rent Expense . . . . Equipment Rent Expense Utilities Expense . . . . . . Music Expense . . . . . . . . Advertising Expense . . . . Supplies Expense . . . . . . Miscellaneous Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,330 1,760 920 3,360 5,000 5,750 4,800 10,000 2,250 11,210 2,800 2,600 1,150 860 1,780 1,300 180 470 31,760 31,760 The data needed to determine adjustments for the two-month period ending May 31, 2006, are as follows: a. During May, Dancin Music provided guest disc jockeys for KPRG for a total of 110 hours. For information on the amount of the accrued revenue to be billed to KPRG, see the contract described in the May 3, 2006 transaction at the end of Chapter 2. b. Supplies on hand at May 31, $170. c. The balance of the prepaid insurance account relates to the May 1, 2006 transaction at the end of Chapter 2. d. Depreciation of the office equipment is $100. e. The balance of the unearned revenue account relates to the contract between Dancin Music and KPRG, described in the May 3, 2006 transaction at the end of Chapter 2. f. Accrued wages as of May 31, 2006, were $130. Instructions 1. Prepare adjusting journal entries. You will need the following additional accounts: 18 22 57 58 Accumulated Depreciation—Office Equipment Wages Payable Insurance Expense Depreciation Expense 2. Post the adjusting entries, inserting balances in the accounts affected. 3. Prepare an adjusted trial balance. 66124_c03_101-138.qxd 11/10/03 8:09 PM Page 136 136 Chapter 3 • The Matching Concept and the Adjusting Process Special Activities ACTIVITY 3-1 Ethics and professional conduct in business ACTIVITY 3-2 Accrued expense ACTIVITY 3-3 Accrued revenue Ruth Harbin opened Macaw Real Estate Co. on January 1, 2005. At the end of the first year, the business needed additional capital. On behalf of Macaw Real Estate, Ruth applied to First City Bank for a loan of $120,000. Based on Macaw Real Estate’s financial statements, which had been prepared on a cash basis, the First City Bank loan officer rejected the loan as too risky. After receiving the rejection notice, Ruth instructed her accountant to prepare the financial statements on an accrual basis. These statements included $41,500 in accounts receivable and $13,200 in accounts payable. Ruth then instructed her accountant to record an additional $12,500 of accounts receivable for commissions on property for which a contract had been signed on December 28, 2005, but which would not be formally “closed” and the title transferred until January 20, 2006. Ruth then applied for a $120,000 loan from Second National Bank, using the revised financial statements. On this application, Ruth indicated that she had not previously been rejected for credit. Discuss the ethical and professional conduct of Ruth Harbin in applying for the loan from Second National Bank. On December 30, 2006, you buy a Ford Expedition. It comes with a three-year, 36,000-mile warranty. On January 18, 2007, you return the Expedition to the dealership for some basic repairs covered under the warranty. The cost of the repairs to the dealership is $725. In what year, 2006 or 2007, should Ford Motor Co. recognize the cost of the warranty repairs as an expense? The following is an excerpt from a conversation between Nathan Cisneros and Sonya Lucas just before they boarded a flight to Paris on American Airlines. They are going to Paris to attend their company’s annual sales conference. Nathan: Sonya, aren’t you taking an introductory accounting course at college? Sonya: Yes, I decided it’s about time I learned something about accounting. You know, our annual bonuses are based upon the sales figures that come from the accounting department. Nathan: I guess I never really thought about it. Sonya: You should think about it! Last year, I placed a $300,000 order on December 27. But when I got my bonus, the $300,000 sale wasn’t included. They said it hadn’t been shipped until January 5, so it would have to count in next year’s bonus. Nathan: A real bummer! Sonya: Right! I was counting on that bonus including the $300,000 sale. Nathan: Did you complain? Sonya: Yes, but it didn’t do any good. Beth, the head accountant, said something about matching revenues and expenses. Also, something about not recording revenues until the sale is final. I figure I’d take the accounting course and find out whether she’s just jerking me around. Nathan: I never really thought about it. When do you think American Airlines will record its revenues from this flight? Sonya: Mmm . . . I guess it could record the revenue when it sells the ticket . . . or . . . when the boarding passes are taken at the door . . . or . . . when we get off the plane . . . or when our company pays for the tickets . . . or . . . I don’t know. I’ll ask my accounting instructor. 66124_c03_101-138.qxd 11/10/03 8:09 PM Page 137 Chapter 3 • The Matching Concept and the Adjusting Process 137 Discuss when American Airlines should recognize the revenue from ticket sales to properly match revenues and expenses. ACTIVITY 3-4 Adjustments and financial statements Several years ago, your brother opened Chestnut Television Repair. He made a small initial investment and added money from his personal bank account as needed. He withdrew money for living expenses at irregular intervals. As the business grew, he hired an assistant. He is now considering adding more employees, purchasing additional service trucks, and purchasing the building he now rents. To secure funds for the expansion, your brother submitted a loan application to the bank and included the most recent financial statements (shown below) prepared from accounts maintained by a part-time bookkeeper. Chestnut Television Repair Income Statement For the Year Ended August 31, 2006 Service revenue . . . . . . . . . . Less: Rent paid . . . . . . . . . . . Wages paid . . . . . . . . . Supplies paid . . . . . . . . Utilities paid . . . . . . . . Insurance paid . . . . . . . Miscellaneous payments Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $83,280 $20,000 18,500 5,100 3,175 2,400 2,150 51,325 $31,955 Chestnut Television Repair Balance Sheet August 31, 2006 Cash . . . . . . . . . . . . . . . . . . . Amounts due from customers Truck . . . . . . . . . . . . . . . . . . Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Assets ...... ...... ...... ...... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $11,150 6,100 30,000 $47,250 Equities Owner’s capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $47,250 After reviewing the financial statements, the loan officer at the bank asked your brother if he used the accrual basis of accounting for revenues and expenses. Your brother responded that he did and that is why he included an account for “Amounts Due from Customers.” The loan officer then asked whether or not the accounts were adjusted prior to the preparation of the statements. Your brother answered that they had not been adjusted. a. Why do you think the loan officer suspected that the accounts had not been adjusted prior to the preparation of the statements? b. Indicate possible accounts that might need to be adjusted before an accurate set of financial statements could be prepared. ACTIVITY 3-5 Codes of ethics Obtain a copy of your college or university’s student code of conduct. In groups of three or four, answer the following question. 1. Compare this code of conduct with the accountant’s Codes of Professional Conduct, which is linked to the text Web site at http:/ /warren.swlearning.com. 2. One of your classmates asks you for permission to copy your homework, which your instructor will be collecting and grading for part of your overall term grade. Although your instructor has not stated whether one student may or may not copy another student’s homework, is it ethical for you to allow your classmate to copy your homework? Is it ethical for your classmate to copy your homework? 66124_c03_101-138.qxd 11/10/03 8:09 PM Page 138 138 Chapter 3 • The Matching Concept and the Adjusting Process ACTIVITY 3-6 Business strategy Assume that you and two friends are debating whether to open an automotive and service retail chain that will be called Auto-Mart. Initially, Auto-Mart will open three stores locally, but the business plan anticipates going nationwide within five years. Currently, you and your future business partners are debating whether to focus Auto-Mart on a “do-it-yourself” or “do-it-for-me” business strategy. A “do-it-yourself” business strategy emphasizes the sale of retail auto parts that customers will use themselves to repair and service their cars. A “do-it-for-me” business strategy emphasizes the offering of maintenance and service for customers. 1. In groups of three or four, discuss whether to implement a “do-it-yourself” or “do-it-for-me” business strategy. List the advantages of each strategy and arrive at a conclusion as to which strategy to implement. 2. Provide examples of real world businesses that use “do-it-yourself” or “do-it-forme” business strategies. A nswers to Self-Examination Questions 1. A A deferral is the delay in recording an expense already paid, such as prepaid insurance (answer A). Wages payable (answer B) is considered an accrued expense or accrued liability. Fees earned (answer C) is a revenue item. Accumulated depreciation (answer D) is a contra account to a fixed asset. 2. D The balance in the supplies account, before adjustment, represents the amount of supplies available. From this amount ($2,250) is subtracted the amount of supplies on hand ($950) to determine the supplies used ($1,300). Since increases in expense accounts are recorded by debits and decreases in asset accounts are recorded by credits, answer D is the correct entry. 3. C The failure to record the adjusting entry debiting unearned rent, $600, and crediting rent revenue, $600, would have the effect of overstating liabilities by $600 and understating net income by $600 (answer C). 4. C Since increases in expense accounts (such as depreciation expense) are recorded by debits and it is customary to record the decreases in usefulness of fixed assets as credits to accumulated depreciation accounts, answer C is the correct entry. 5. D The book value of a fixed asset is the difference between the balance in the asset account and the balance in the related accumulated depreciation account, or $22,500 Ϫ $14,000, as indicated by answer D ($8,500). ...
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This note was uploaded on 10/03/2009 for the course ACTG ACTG 1A taught by Professor Seyedin during the Winter '08 term at Foothill College.

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