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Solutions Manual, Chapter 3 65 3 ADJUSTMENTS FOR FINANCIAL REPORTING ANSWERS TO QUESTIONS 1. Normal journal entries during the accounting period are triggered by the giving, receiving, or creating of a source document. Adjusting entries are triggered by the arrival of the end of the accounting period. 2. The cash basis of accounting recognizes revenues when cash is received and recognizes expenses when cash is paid. The accrual basis recognizes revenues when sales are made or services are performed, regardless of when cash is received. Expenses are recognized as incurred, whether or not cash has been paid out. 3. Adjusting entries are needed to record previously unrecorded assets, liabilities, expenses, and revenues. The student must also understand the matching concept to understand why adjusting entries are necessary. An illustration can be used to show how income is distorted when the pure cash basis is used. For instance, if a $50,000 building is recorded as an expense in the year it is purchased (or built), a company might show a huge net loss for that year and substantial income over the remaining life of the building. For business income to be computed in a meaningful way, the expenses of earning revenue should be deducted in the same accounting periods in which the revenues are recorded. The building was acquired to provide services over a number of years. Therefore, its cost should be amortized over the same time period as the revenues that are realized from its use. This method of recording revenues when earned and realized and expenses when incurred is called the accrual basis of accounting. The cash basis records revenues when received and expenses when paid. While the latter is easier to apply, the former gives a more meaningful measure of the performance of a business over a period of time. 4. The statement is true for the "pure" cash basis. However, under modified cash basis accounting, a building would be treated as an asset and depreciated over its useful life with all other expenses generally recognized when cash is paid for them. Revenues would typically be recognized only when cash is received. Thus, as a generalization, the contention that it is the application of the accrual basis of accounting that makes adjusting entries necessary is true. 5. The effort involved could be enormous. Some amounts are literally earned (or incurred) continuously. For instance, the interest earned (incurred) on Notes Receivable (Payable) would have to be recorded each second of each day if the accounts were to be kept at their proper balances continuously. Since this is impractical, the accountant waits until some significant event occurs (such as the receipt or payment of interest or the arrival of the end of the accounting period) before bringing the accounts to their proper balances. 6. Deferred items consist of adjusting entries involving data previously recorded in the
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