Hi Katrina,

I have another accounting problem I need your help with. It's similar to the one you did on 4/4/2016. The due date for this one will be 4/10/2016, Will you be able to help? See below details.

Open the Guidance Report and rework the problem with the changed numbers. The changed numbers should be column mar-apr. Basicly you will be using mar-apr values in place of orignal values in problem. An example would be probllem 1 on spreadsheet: Fish trip orginal amount is 125 it would need to be changed to 175 and Boat rental orginal amount is 72,000 it would need to be changed to 84,000. You only need to answer question on spreadsheet. No need to answer questions in book. I am only attaching book so you will have all values needed to complete the problem. Chapter Three, Exercises 4 and 8 Chapter Four, Exercises 3 and 6 Chapter Three, Problem 3 Chapter Four, Problem 3

chapter 3 Income Measurement and the Accounting Cycle Copyright Barbara Chase/Corbis/AP Images Learning Goals Understand fundamental concepts of income measurement and the accrual basis of accounting. Apply the core principles that define revenue and expense recognition methods. Know why adjusting entries are needed and prepare them for the illustrated types of transaction and events. Implement the accounting cycle and the steps that lead to preparing correct financial statements. Construct a worksheet to aid in preparing financial statements. Cite examples of alternative reporting periods and show how the closing process is used at the end of a typical accounting year. Calculate income under the cash basis of accounting and know when it is an acceptable alternative to the accrual basis. waL80144_03_c03_053-088.indd 1 8/29/12 2:43 PM Section 3.1 An Emphasis on Transactions and Events CHAPTER 3 Chapter Outline 3.1 An Emphasis on Transactions and Events 3.2 The Periodicity Assumption 3.3 Revenue Recognition 3.4 Expense Recognition 3.5 Adjusting Entries The Adjusting Process for Revenues The Adjusting Process for Expenses Understanding When to Adjust 3.6 The Accounting Cycle A Comprehensive Example The Adjusted Trial Balance Financial Statement Preparation 3.7 Reporting Periods and Worksheets Closing the Accounts Classified Balance Sheets Notes to the Financial Statements 3.8 Cash Basis of Accounting C hapter 2 showed how transactions are entered into the journal and posted to the ledger. The resulting ledger balances were drawn into a trial balance to verify that debit and credit figures matched. In some cases, the trial balance can be used to prepare financial statements. Also pointed out was that accountants often need to adjust certain accounts before up-to-date and correct financial statements can be prepared. 3.1 An Emphasis on Transactions and Events T he basis for determining which accounts require adjustment is tied to understanding the fundamental nature of accounting income. Accounting income is primarily tied to a model based on transactions and events. This means that accountants are not necessarily measuring all changes in value as they occur. The historical cost principle is the foundation to many accounting rules. For example, land is recorded at its purchase price, and that historical cost price is maintained in the balance sheet, even though market value may increase over time. Historical cost data are viewed as objective and verifiable. The prevailing income measurement model is primarily driven by a transactions-and-events, historical cost-based approach. The historical cost information incorporated into the accounting system is drawn from exchange transactions. Exchange transactions generally signify that independent buyers and sellers have agreed on the price for which goods are services are to be delivered. waL80144_03_c03_053-088.indd 2 8/29/12 2:43 PM CHAPTER 3 Section 3.2 The Periodicity Assumption These exchanges are often termed arm's length exchange transactions, and the amount of consideration forms the basis for accounting measurement. Business revenues are the resource (generally, cash and receivables) inflows from exchange transactions. Business expenses are the exchange-related resource outflows arising from the production of goods and services. Income is generally regarded as revenues minus expenses. One seemingly unavoidable problem with the approach based on transactions and events is the dynamic nature of business activity. Revenue- and expense-generating activities are in constant flux. Each day a business may provide services to customers, but payment occurs only on a specified billing cycle. When is the revenue viewed as being earned for purposes of inclusion in an income statement? Similarly, many business expenses are being continuously generated. Consider the consumption of electricity. At the moment you are reading this, you may be sitting in a heated or air conditioned room, illuminated by an overhead light, with your computer on. Electricity is being consumed constantly. From a business perspective, the cost associated the electricity usage is constantly ongoing. How should the measure of electricity expense be pulled into the measure of accounting income? 3.2 The Periodicity Assumption T he periodicity assumption holds that that business activity can be divided into specific time intervals, such as months, quarters, and years. Indeed, recall that an income statement measures income for a specific time period. Furthermore, a balance sheet reflects the financial condition as of a specific date. The significance of the periodicity assumption and the related financial statement dating cannot be underestimated. The transactional basis of accounting measurement is not to be interpreted as measuring only the exchange of cash. The cash basis of accounting will be discussed later in this chapter. For now, the focus is on the accrual basis. Accrual is a term that means \"to accumulate over time, based on a natural observable increase.\" For example, a business will constantly use utilities. The cost of those utilities accrues, or accumulates, with the passage of time. The accrual basis attempts to measure these costs as they accumulate. In contrast, the cash basis would measure the utilities expense only when the utility bill is paid. A key challenge of the accrual basis of accounting is properly identifying the portion of ongoing business activity that occurred during a particular accounting period, as Exhibit 3.1 shows. Exhibit 3.1: Measuring ongoing activity BUSINESS ACTIVITY Accounting Year 55 waL80144_03_c03_053-088.indd 3 8/29/12 2:43 PM CHAPTER 3 Section 3.3 Revenue Recognition Identifying the amount of business activity to measure in each period involves both revenue and expense issues. Principles that guide the measurement of each are discussed in the following sections of this chapter. 3.3 Revenue Recognition U nder the accrual basis of accounting, revenues are to be recorded when they are earned. The measurement of revenue is called revenue recognition and is synonymous with recording revenues into the accounts. Revenue recognition normally occurs at the time when services are rendered or when goods are sold and delivered to a customer. Revenue recognition normally requires both an exchange transaction and the earnings process to be complete (Exhibit 3.2). Exhibit 3.2: Revenue recognition + Production Earnings Process Complete = Salesman Customer Exchange Transaction Accounting Revenue Recognition For a manufactured product, revenue should not be recorded until the product is sold and delivered to an end customer. Payment can occur before, after, or at the time of product delivery. What matters is that the customer has accepted the product and the associated duty to pay for it. It is also imperative that the product be completed, such that the manufacturer has no significant remaining duties (other than honoring routine commitments related to warranty services or occasional estimable returns). Service revenue is not as closely tied to the handoff to an end customer. A law firm may have a large staff that is researching a unique problem. The work is ongoing, and the client is being regularly updated on findings. So long as the law firm reasonably expects to be paid, the earnings process and the related revenue recognition is continuous. Business transactions are fraught with complexity and give rise to numerous revenue recognition challenges. A majority of significant accounting mistakes relate to misapplication of generally accepted accounting principles related to revenue recognition issues. Consider the complexity of revenue recognition for cases like those related to long-term service agreements. Perhaps you have had an offer for a $99 cell phone, satellite dish, or burglar alarm system. The item you are buying likely costs more than $99, and the terms of the offer probably require you to agree to a multiyear monthly service contract. How should the seller record such transactions? waL80144_03_c03_053-088.indd 4 8/29/12 2:43 PM Section 3.4 Expense Recognition CHAPTER 3 What about an online retailer whose business model only requires routing a customer order to a supplier who handles all logistics? If an item is sold for $100, but the online company only retains $2 of the total as a marketing fee, how much revenue is to be reported on the income statement? These are complex questions, which can lead to more complex questions. It is no wonder that many accounting failures involve misapplication of revenue recognition concepts. Accountants have literally thousands of specific rules to draw on in reaching correct accounting conclusions. Those specific rules are generally framed around the principles in Table 3.1, all of which should be satisfied. Table 3.1: General principles for revenue recognition There is persuasive evidence of an arrangement. Delivery of goods has occurred or services have been rendered. The seller's price is fixed or determinable. Collectability is reasonably assured. Remember from Chapter 2 that accounting is not bookkeeping. Perhaps you are now beginning to appreciate the difference. Accountants are highly skilled professionals who are trained to research and apply proper accounting solutions to complex measurement issues. For now, it bears repeating that payment is not a criterion for initial revenue recognition. Revenues are recognized at the point of sale, whether that sale is for cash or a receivable. Accrual basis accounting contemplates more than just recording cash receipts. Severe misrepresentations of income could result if the focus was simply on cash receipts. 3.4 Expense Recognition A ccrual accounting principles also apply to expense recognition. Expense recognition principles have a slightly different theoretical framework. There are three alternative models to apply, depending on the nature of a particular cost. Some costs are created by and directly associated with a particular revenue-producing event. For example, the sale of an inventory item produces revenue, and it makes sense to offset the revenue by the cost of the inventory. Remember, income is equal to revenues minus expenses. Failure to record the expenses associated with producing revenue would overstate income. Sales commissions would similarly be recorded in the same period as a sale. Many costs bear a direct relationship to revenue and are to be recorded concurrent with the revenue recognition. This concept is referred to as the matching principle. The matching principle explains the manner in which a large proportion of business costs are to be recorded. Some costs occur on an ongoing basis without regard to the level of revenue production. Rent, insurance, depreciation of equipment, and so forth are costs that display this pattern. As such, accountants adopt systematic allocation schemes. These schemes can be as simple as recording an equal portion of cost each period. Other patterns might be waL80144_03_c03_053-088.indd 5 8/29/12 2:43 PM CHAPTER 3 Section 3.5 Adjusting Entries deployed, such as accounting for long-term assets (see Chapter 6). Therefore, accountants use defined allocation models to systematically attribute some costs to expense over time. Lastly, some costs occur that are not seen as benefiting any future periods and are not linked to any revenue production. If a business asset is consumed by fire, its cost would be expensed immediately; there is no future benefit and no discernible revenue! Therefore, the third approach to recording expenses is immediate recognition. Recapping, expenses are recognized by matching, systematic allocation, or immediate recognition, as shown in Exhibit 3.3. Exhibit 3.3: T\u0007 he three approaches to expense allocation Year 1 Year 2 Year 8 20XX Year 3 Year 7 $ Expenses $$$ $ Revenues Year 4 Year 6 Year 5 Matching Allocation Immediate Accountants use the logic just described in trying to decide which approach to apply to a particular cost. As was the case with revenue recognition, note that expense recognition guidelines look well beyond just the payment of cash. Many costs are charged to expense in advance of or after the date of the related cash payment. For instance, the purchase of equipment for cash is initially recorded as follows: 7-1-X2 Equipment Cash 1,000.00 1,000.00 To record purchase of equipment Over time, the equipment cost will be transferred to expense in a systematic fashion that approximates the consumption of the equipment via its usage. This process is called depreciation and is discussed later in this chapter. 3.5 Adjusting Entries T he revenue and expense recognition principles provide a foundation for understanding the potential need to adjust account balances prior to preparing financial statements. Revenues may have been earned and expenses incurred that have not yet been recorded. waL80144_03_c03_053-088.indd 6 8/29/12 2:43 PM CHAPTER 3 Section 3.5 Adjusting Entries Conversely, asset and liability accounts may contain balances that are no longer valid. Actually, there are countless scenarios of potential adjustments that go well beyond what can be illustrated in a text. The good news is that if you develop a conceptual understanding of the basis on which adjustments are to be prepared, that knowledge can be extended to develop logical solutions for almost any adjustment-related problem you may encounter. Adjusting entries are journal entries that are necessary to cause asset, liability, revenue, expense, and all other accounts to contain their correct balance as of a particular reporting date. As a frame of reference, Table 3.2 describes various types of adjusting entries that are necessary for selected revenue and expense items. Notice that revenue and expense accounts are both subject to adjustments for accruals and unearned/prepaid elements. Table 3.2: Types of adjusting entries Adjusting Revenues Accrued revenues Unearned revenue Adjusting Expenses Typical expense accruals (payroll, interest, rent) Prepaids (Insurance, rent, supplies) Depreciation The Adjusting Process for Revenues To begin, let's consider the concept of accrued revenue. As mentioned earlier, accruals relate to items that accumulate with the passage of time. A law firm that provides services to clients accrues additional revenue with each hour of service provided to a client. Hours of service are tracked and periodically billed. Accordingly, revenues may be earned during one month and billed the following. Notwithstanding the billing cycle, revenues should be recorded as earned. When financial statements are prepared, an adjusting entry may be necessary to accrue earned but unbilled revenue. To illustrate, assume that a company is owed $900 as of December 31, 20X5, for services rendered but not yet billed: 12-31-X5 Accounts Receivable Revenue 900.00 900.00 Year-end adjusting entry to reflect services provided by year-end An alternative revenue scenario arises when payments are received in advance of providing services. A law firm might require an advance payment from a new client. Because work has yet to be performed, the amounts collected are said to be unearned revenue. A liability is shown on the balance sheet representing the duty to perform in the future. The following entry is used to record the initial cash collection: waL80144_03_c03_053-088.indd 7 8/29/12 2:43 PM CHAPTER 3 Section 3.5 Adjusting Entries 7-1-X2 Cash 1,000.00 Unearned Revenue 1,000.00 To record advance collection from client If 60% of the work contemplated by the preceding entry was performed by year-end, the following entry would be needed to transfer $600 of the unearned revenue: 12-31-X2 Unearned Revenue 600.00 Revenue 600.00 Year-end adjusting entry to reflect earned portion of advance payment The income statement for 20X2 would reflect the $600 of earned revenue, and the balance sheet would reflect the remaining $400 of unearned revenue ($1,000 2 $600). This may seem like a lot of trouble to you. Why not just record the initial $1,000 all as revenue when it is collected? The simple answer is that it violates the fundamental revenue recognition principles. Granted, the monetary amounts were very small in this example. However, the amounts can mount into the hundreds of millions for actual companies. Airlines often presell tickets, funeral homes may presell funeral plans, software companies grant longterm licenses, insurance companies presell coverage, magazine publishers presell multiyear subscriptions, and so forth. Correctly measuring revenue is essential to determining the success or failure of a business enterprise, and proper application of revenue recognition concepts is paramount. The Adjusting Process for Expenses Properly accounting for expenses requires logic very similar to that for revenues. Many expenses accrue with the passage of time. Payroll is a significant cost for many businesses and is an excellent example of an accruing expense. If you think about a job you may have held, you recall showing up daily for work but only being paid periodically. Businesses usually pay employees on a regular interval, such as \"every other Friday.\" If an accounting period ended on a Wednesday and the daily payroll (assume a Monday through Friday workweek, and the last payday was the previous Friday) averaged $5,000, then $15,000 (3 days) of payroll is accrued at the end of the period. The following entry would be needed to accrue this expense: 12-31-X6 Salaries Expense Salaries Payable 15,000.00 15,000.00 To record accrued salaries at end of period Failure to record this adjusting entry would result in understating expenses (and overstating income!) by $15,000. Further, the balance sheet would fail to reflect that $15,000 is owed to employees. waL80144_03_c03_053-088.indd 8 8/29/12 2:43 PM CHAPTER 3 Section 3.5 Adjusting Entries You may be wondering what will happen on the next payday? If $50,000 is paid (10 days at $5,000 per day) on the next payday, the appropriate entry needs to reflect that $15,000 of the amount relates to the previous accrual (i.e., it is paid to satisfy the already recorded liability), and the other $35,000 relates to work performed in the new accounting period: 1-9-X7 Salaries Expense 35,000.00 Salaries Payable 15,000.00 Cash 50,000.00 To record payment of payroll overlapping the end of an accounting period You should carefully compare the preceding entries to Exhibit 3.4 and note how they result in the assignment of the correct amount of expense to each of the affected accounting periods. Exhibit 3.4: Assigning expenses to accounting periods December 20X6 S 7 January 20X7 M T W T F S 1 2 3 4 5 6 8 9 10 11 12 13 S 4 M T 5 6 W 7 T F S 1 2 3 8 9 10 14 15 16 17 18 19 20 11 12 13 14 15 16 17 21 22 23 24 25 26 27 18 19 20 21 22 23 24 28 29 30 31 25 26 27 28 29 30 31 Paydays Paid Holiday Accruals Days Paid for on 9th Another example of an accruing expense is interest on a loan. Interest is the cost for using money and is ordinarily assessed as a stated percentage of the amount borrowed and further based on the length of the borrowing period. Therefore, accrued interest on a loan can be calculated using the borrowed amount (principal), the interest rate (rate), and the length of the borrowing period (time). A simple formula becomes Principal Rate Time For example, if $10,000 is borrowed at 8% per year for 24 months, the total interest will amount to $1,600 ($10,000 8% 2 years). Agreements with respect to the frequency of interest payments vary considerably. Some lenders may require monthly checks for accumulated interest. Other times, a loan may stipulate that interest only be paid quarterly, annually, or at maturity of the loan. Therefore, it is often necessary to record an adjusting entry to record the amount of accrued interest at the end of an accounting period. If our waL80144_03_c03_053-088.indd 9 8/29/12 2:43 PM CHAPTER 3 Section 3.5 Adjusting Entries 24-month loan was taken out on July 1, 20X3, and all amounts became due on June 30, 20X5, then all the following entries would be needed over the lifecycle of the transaction: 20X3 7-1-X3 Cash 10,000.00 Loan Payable 10,000.00 Borrowed $10,000 at 8% per annum; principal and interest due on 6-30-X5 12-31-X3 Interest Expense 400.00 Interest Payable 400.00 To record accrued interest for 6 months ($10,000 3 8% 3 6412) 20X4 12-31-X4 Interest Expense 800.00 Interest Payable 800.00 To record accrued interest for 12 months ($10,000 3 8% 3 12412) 20X5 6-30-X5 Interest Expense 400.00 Interest Payable 1,200.00 Loan Payable 10,000.00 Cash 11,600.00 To record repayment of loan and interest The complexity is growing, as you can tell. It is important for you to note that the loan spanned three accounting periods and expense was allocated to each via these entries. Because the loan was outstanding for 6 months in 20X3, 12 months for 20X4, and 6 months for 20X5, the interest expense was similarly allocated as $400, $800, and $400, respectively. Rent sometimes gives rise to an adjusting entry. If a business actually pays rent after the period of time for which facilities are used, then the accumulated unpaid rent at any time is the amount of accrued rent. If a company had accrued rent expense amounting to $4,000 at the end of period, the following entry would be needed: 12-31-X3 Rent Expense Rent Payable 4,000.00 4,000.00 To record accrued rent at end of period In contrast to accrued expenses are prepaid expenses. Prepaid expenses would be costs you pay in advance. You probably have some experience with this in the form of rent or insurance. Your landlord might collect a month's rent in advance each period, or your insurance company might collect on your car insurance every 6 months. The initial expenditure represents a future economic benefit and is recorded as an asset. As time passes, the asset is consumed and should be transferred to expense with an adjusting entry. waL80144_03_c03_053-088.indd 10 8/29/12 2:43 PM CHAPTER 3 Section 3.5 Adjusting Entries To illustrate, assume you purchased a $600 6-month auto insurance policy on October 1. The following entry would be needed to record the initial policy purchase: 10-1-X8 Prepaid Insurance 600.00 Cash 600.00 Prepaid a 6-month insurance policy for cash By December 31, half of the insurance coverage has been used up. This adjusting entry transfers $300 of the asset to expense: 12-31-X8 Insurance Expense 300.00 Prepaid Insurance 300.00 To adjust prepaid insurance to reflect portion expired The income statement for 20X8 would show an insurance expense of $300, reflecting the amount of coverage purchased and used. The balance sheet would reflect the other $300 of prepaid insurance relating to January, February, and March. Prepaid rent arises when you pay rent in advance. Assume that an office is leased on August 1 by paying $3,000 that covers the right to use the property for August, September, and October. The following entry would be needed to record the initial payment on August 1: 8-1-X7 Prepaid Rent 3,000.00 Cash 3,000.00 Prepaid a 3-month lease At the end of each month (August, September, and October), the following entry would be need to transfer $1,000 of the prepaid rental asset to an expense account. This reflects consumption of the service via its conversion to an expense. End of Month Rent Expense Prepaid Rent 1,000.00 1,000.00 To adjust prepaid rent to reflect portion consumed waL80144_03_c03_053-088.indd 11 8/29/12 2:43 PM CHAPTER 3 Section 3.5 Adjusting Entries The T-accounts in Exhibit 3.5 illustrate the rental payment and the related assignment to expense over time. Exhibit 3.5: T-accounts for 3 months of prepaid rent Supplies are another form of prepaid expenses. When supplies are purchased, the following entry will probably be recorded: 12-1-X5 Supplies 5,000.00 Cash 5,000.00 Purchased $5,000 of office supplies If $3,000 of these supplies is used during the month, the end-of-month adjusting entry would be as follows: 12-31-X5 Supplies Expense Supplies 3,000.00 3,000.00 Purchased $3,000 of office supplies waL80144_03_c03_053-088.indd 12 8/29/12 2:43 PM CHAPTER 3 Section 3.5 Adjusting Entries The preceding entry both reduces the Supplies account (from $5,000 to $2,000) to equal the amount still on hand and transfers the amount consumed to Supplies Expense. You may be wondering how you would actually determine the supplies used during a period, especially if there is a beginning supply already on hand. It is probably not practical to track each item (and its cost) as it is used. Instead a business would rely on the formulations in Table 3.3. Table 3.3 Determining supplies used Beginning balance of supplies Plus: Purchases Equals: Supplies available Supplies available Less: Ending supplies on hand Amount used that should be expensed If you can visualize a supplies closet, imagine that it contained $500 of supplies (determined by a physical count) at the beginning of an accounting period. During the period, an additional $1,000 of goods were purchased and placed in the closet. If a physical count at the end of the period revealed $300 of supplies, you could conclude that $1,200 worth of supplies was actually used (Table 3.4). Table 3.4 Beginning balance Plus: Purchases Supplies available Less: Ending supplies on hand Supplies used $ 500 1,000 $1,500 300 $1,200 Certain assets have a much longer life than that shown for the prepaid insurance, and they may be tangible in nature (you can touch them). Examples include a business's buildings and equipment. The accounting logic that must be deployed is to record the purchase of such assets and then gradually (remember systematic and rational allocation concepts) transfer their cost to expense. We call this process depreciation. The logic is not that much different from that applied to prepaid insurance; it just spans a much longer horizon. waL80144_03_c03_053-088.indd 13 8/29/12 2:43 PM CHAPTER 3 Section 3.5 Adjusting Entries Importantly, depreciation is not a matter of valuing assets of a business but is the transference of an asset's cost to expense over the expected life of the asset. Accountants have devised several methods for measuring periodic depreciation, but the easiest is just a straight-line approach. With this technique, an equal amount of asset cost is assigned to each year of service life. For example, if an item of equipment has a $6,000 cost and 3-year life, it is as simple as recording $2,000 of expense each year. It is important for you to note that the depreciation has nothing to do with cash or providing cash for an asset's eventual replacement. The only cash flow occurs at the time an asset is purchased. As you will see from the following entries, the depreciation transfers the cost to expense over time but has not further bearing on cash. The basic journal entry to record annual depreciation entails a debit to Depreciation Expense. The way in which accountants prepare the offsetting credit is unique. Rather than crediting the asset account directly (as we did for prepaid insurance), they instead credit an account called Accumulated Depreciation: 12-31-XX Depreciation Expense Accumulated Depreciation 2,000.00 2,000.00 To record annual depreciation expense Accumulated depreciation is shown on the balance sheet as a subtraction from the equipment that it relates to. Contra is a term that means \"opposed to,\" and an account that is subtracted from another related account is called a contra asset. In other words, contra assets are subtracted from the account to which they relate. Each year's balance sheet would report the asset at its $5,000 cost but with a reducing offset for the cumulative depreciation to date. This approach helps balance sheet users' ability determine at a glance the investment and relative age of a business's productive asset pool. Exhibit 3.6 illustrates how this item of equipment would appear in the financial statements over its 3-year life. waL80144_03_c03_053-088.indd 14 8/29/12 2:43 PM CHAPTER 3 Section 3.5 Adjusting Entries Exhibit 3.6: T\u0007 he cumulative depreciation of equipment over 3 years $6,000 is paid on January 1, 20X1, for equipment with a three-year life Balance Sheet January 1, 20X1 Income Statement For the Year Ending December 31, 20X1 Assets Depreciation Expense Truck $ 2,000 $ 6,000 Less: Accumulated Depreciation - $ 6,000 Balance Sheet December 31, 20X1 20X1 Income Statement Income Statement For the Year Ending December 31, 20X2 Assets Depreciation Expense Truck $ 6,000 Less: Accumulated Depreciation (2,000) $ 4,000 Balance Sheet December 31, 20X2 $ 2,000 20X2 Income Statement Income Statement For the Year Ending December 31, 20X3 Assets Depreciation Expense Truck $ 6,000 Less: Accumulated Depreciation (4,000) $ 2,000 $ 2,000 20X3 Income Statement Balance Sheet December 31, 20X3 Assets Truck $ 6,000 Less: Accumulated Depreciation (6,000) $0 Perhaps it is obvious, but do take special note that contra accounts have opposite debit and credit rules. For instance, accumulated depreciation is a contra asset and is increased with a credit. Understanding When to Adjust A person must be very familiar with the workings of a particular business to know which accounts need adjustment at the end of each accounting period. This is a task that requires someone who understands accounting measurement and has a deep knowledge of a waL80144_03_c03_053-088.indd 15 8/29/12 2:43 PM CHAPTER 3 Section 3.6 The Accounting Cycle particular business. It is easy to overlook selected adjustments, and when that happens, the information communicated by the financial statements is in error. Auditors routinely keep a sharp eye on the need for adjustments that might otherwise go overlooked. In Chapter 2, you saw how a trial balance could be used to prepare financial statements. You were also cautioned that the trial balance may not be up-to-date and the actual preparation of financial statements would normally follow the adjusting process that you are now familiar with. Therefore, after adjusting entries are prepared and posted, you would construct an adjusted trial balance showing that the equality of debits and credits was preserved throughout the journalization and posting of all adjustments. 3.6 The Accounting Cycle R eviewing thus far, you should now recognize that the accounting process reflects the following steps: 1. Examine source documents. 2. Record transactions in the journal. 3. Post journal entries to the indicated ledger accounts. 4. Perhaps construct a trial balance. 5. Determine and post adjusting entries. 6. Prepare an adjusted trial balance. 7. Prepare financial statements from the adjusted trial balance. These steps are customarily referred to as the accounting cycle (Exhibit 3.7), and it is vital that you comprehend how this process leads to the capture and communication of essential accounting information. Exhibit 3.7: The accounting cycle 1 5 waL80144_03_c03_053-088.indd 16 3 2 $$ $ $$ $ 6 4 7 8/29/12 2:43 PM CHAPTER 3 Section 3.6 The Accounting Cycle A Comprehensive Example At this juncture, it may prove helpful to review a comprehensive example. Assume that Clark Gliders is in the process of preparing financial statements for the year ending 20X5, its first year of operation. Clark Gliders operates out of the Windy Draft Airfield and provides glider rides and tours for paying passengers. On January 1, 20X5, Clark Gliders received a $40,000 initial investment from shareholders and borrowed an additional $100,000 (at 6% per annum). Much of this money was invested in gliders with estimated lives of 10 years. Its trial balance reflecting 20X5 activity, prior to considering the need for adjusting entries, contained the balances shown in Exhibit 3.8. Exhibit 3.8: Trial balance for Clark Gliders Clark Gliders Trial Balance December 31, 20X5 Debits Cash Accounts receivable Prepaid hangar rent Gliders Accounts payable Unearned revenue Loans payable Capital stock Dividends Revenue Flight expense Wages expense Credits $ 110,000 15,000 12,000 90,000 $ 32,000 5,000 100,000 40,000 6,000 143,000 60,000 27,000 $ 320,000 - $ 320,000 Assume that Clark determined that the following adjusting entries were needed at the end of 20X5. waL80144_03_c03_053-088.indd 17 8/29/12 2:43 PM CHAPTER 3 Section 3.6 The Accounting Cycle 12-31-X5 Depreciation Expense 9,000.00 Accumulated Depreciation 9,000.00 To record annual depreciation expense of gliders ($90,000410) 12-31-X5 Wages Expense 3,000.00 Wages Payable 3,000.00 To record accrued wages due to employees at the end of December 12-31-X5 Interest Expense 6,000.00 Interest Payable 6,000.00 To record accrued interest on note payable ($100,000 3 6%) 12-31-X5 Unearned Revenue 3,000.00 Revenue 3,000.00 Year-end adjusting entry to reflect earned portion of rides sold in advance 12-31-X5 Rent Expense Prepaid Hanger Rent 4,000.00 4,000.00 Year-end adjusting entry to reflect consumed portion of hanger rent paid in advance The Adjusted Trial Balance Review the preceding entries and consider why they might be necessary (the amounts are simply assumed). Then, examine the adjusted trial balance in Exhibit 3.9 and take careful note of how the trial balance was updated for the effects of the adjusting entries. waL80144_03_c03_053-088.indd 18 8/29/12 2:43 PM CHAPTER 3 Section 3.6 The Accounting Cycle Exhibit 3.9: Adjusted trial balance for Clark Gliders Clark Gliders Adjusted Trial Balance December 31, 20X5 Debits Credits $ 110,000 15,000 8,000 90,000 Cash Accounts receivable Prepaid hangar rent Gliders Accumulated depreciation Accounts payable Unearned revenue Wages payable Interest payable Loans payable Capital stock Dividends Revenue Flight expense Wages expense Depreciation expense Interest expense Rent expense 9,000 $ 32,000 2,000 3,000 6,000 100,000 40,000 6,000 146,000 60,000 30,000 9,000 6,000 4,000 $ 338,000 - $ 338,000 Financial Statement Preparation The adjusted trial balance is used to prepare financial statements. Trace the amounts from Clark's adjusted trial balance to the financial statements in Exhibits 3.10, 3.11, and 3.12. Exhibit 3.10: Balance sheet for Clark Gliders Clark Gliders Balance Sheet December 31, 20X5 Assets Cash Liabilities $ 110,000 Accounts receivable 15,000 Prepaid hangar rent 8,000 Gliders Less: Accumulated depreciation $ 90,000 (9,000) 81,000 Accounts payable $ 32,000 Unearned revenue 2,000 Wages payable 3,000 Interest payable 6,000 Loans payable 100,000 $ 143,000 Stockholders' equity Capital stock - Total assets waL80144_03_c03_053-088.indd 19 $ 214,000 Retained earnings Total liabilities and equity $ 40,000 31,000 71,000 $ 214,000 8/29/12 2:43 PM CHAPTER 3 Section 3.7 Reporting Periods and Worksheets Exhibit 3.11: Income statement for Clark Gliders Clark Gliders Income Statement For the Month Ending December 31, 20X5 Revenues Services to customers Expenses Flight Wages $ 146,000 $ 60,000 30,000 Depreciation 9,000 Interest 6,000 Rent 4,000 109,000 Total expenses Net income $ 37,000 Exhibit 3.12: Statement of retained earnings for Clark Gliders Clark Gliders Statement of Retained Earnings For the Month Ending December 31, 20X5 Beginning balance - December 1, 20X5 Plus: Net income $ - 37,000 $ 37,000 Less: Dividends Ending balance - December 31, 20X5 6,000 $ 31,000 Notice that the information in the adjusted trial balance is scattered throughout the three financial statements: (1) Assets and liabilities are placed on the balance sheet. (2) Revenues and expenses are placed on the income statement. (3) The statement of retained earnings includes the beginning retained earnings balance (zero, in this case, because this was a new businessbut would otherwise be found in the adjusted trial balance), plus the net income carried forward from the income statement, and minus the dividends from the adjusted trial balance. 3.7 Reporting Periods and Worksheets A company's annual reporting period may follow the natural calendar and run from January 1 to December 31. This is known as a calendar year. In the alternative, some companies report on a fiscal year that runs from one point of beginning to one year later. Fiscal years are often chosen to follow natural business cycles. Such is the case for agricultural companies that may report to match growing and harvesting seasons, retailers that await holiday return cycles, and so forth. waL80144_03_c03_053-088.indd 20 8/29/12 2:43 PM Section 3.7 Reporting Periods and Worksheets CHAPTER 3 In addition to the annual report, a company may prepare monthly and/or quarterly reports. The shorter the reporting cycle, the more assumptions and estimating calculations become necessary. Continuous business activity must be divided and apportioned among periods. Despite the inherent reliance on assumptions, investors and creditors prefer frequent reports. Information timeliness is critical to decision making. A worksheet is often used to prepare monthly and quarterly financial reports. Formal adjusting entries may not be prepared and entered into the journals and ledgers; however, the effects of adjustments must still be taken into consideration. The worksheet aids in this process. Exhibit 3.13 shows a typical worksheet. The data and adjustments found in the worksheet correspond to information previously presented for Clark Gliders. The first pair of columns is the unadjusted trial balance. The next pair reflects all adjustments. The third pair of columns combines the trial balance with the adjustments to produce an adjusted trial balance. Information from the adjusted trial balance is extended to the appropriate financial statement. For example, Cash is an asset account with a debit balance and is extended to the debit column of the balance sheet. A similar extension occurs for every item in the adjusted trial balance. Study this process closely. After all adjusted trial balance amounts have been extended to the appropriate columns, the income statement columns are subtotaled. If credits exceed debits, the company has more revenues than expenses (e.g., $146,000 vs. $109,000 $37,000 net income). An excess of debits over credits would represent a net loss. The amount of net income or loss is transferred from the income statement columns to the statement of retained earnings columns, as shown. Similarly, the ending retained earnings (the excess of credits over debits in the retained earnings columns) is transferred to the balance sheet, as shown. This final transfer should bring the debit and credit columns of the balance sheet into balance (e.g., $223,000 $223,000). Closing the Accounts Reporting periods rarely exceed a year. This means that Revenue, Expense, and Dividend accounts must be reset to a zero balance at the end of an accounting year, prior to beginning the accounting cycle for a new accounting year. This process has resulted in these accounts often being called temporary accounts. This reset is often called \"closing the books.\" Sophisticated computer programs easily accomplish this task (or may skip it all together because it is possible to query a database structure for any designated time interval). However accomplished, the key point is that the temporary accounts are readied to begin accounting anew for the next year's activity. You might think this closing process could be as simple as starting a fresh ledger page for each temporary account. Keep in mind, however, that the ongoing recording of each item of revenue, expense, or dividend does not result in an update of retained earnings. Throughout the accounting cycle, the retained earnings balance reflected in the ledger only shows the beginning-of-period balance. An added goal of closing is to update the retained earnings balance to reflect the end-of period balance. Remember that retained earnings is increased for net income and decreased for dividends. waL80144_03_c03_053-088.indd 21 8/29/12 2:43 PM waL80144_03_c03_053-088.indd 22 Debit 90,000 Gliders 6,000 2,000 32,000 $ 4,000 4,000 4,000 Rent expenses Retained earnings Net income $ 25,000 $ 25,000 $ 320,000 $ 320,000 - $ 146,000 $ $ 37,000 - $ 37,000 6,000 31,000 $ 37,000 $ $ 146,000 $ 146,000 $ 37,000 - 6,000 - 37,000 $ 338,000 $ 338,000 $ 109,000 $ 146,000 - 6,000 - 6,000 Interest payable - 3,000 3,000 Wages payable - 9,000 9,000 Accumulated depreciation - 6,000 6,000 6,000 Interest expense - 9,000 - 30,000 9,000 60,000 30,000 146,000 9,000 60,000 3,000 27,000 Wages expense 143,000 Depreciation expenses 60,000 Flight expenses Revenues Dividends 40,000 3,000 $ 31,000 $ 223,000 6,000 3,000 9,000 40,000 100,000 2,000 32,000 - $ Credit $ 223,000 8,000 Debit 90,000 Credit 90,000 Debit 15,000 Credit 8,000 Debit Balance Sheet 15,000 40,000 3,000 4,000 Credit Statement of Retained Earnings $ 110,000 Debit Income Statement $ 110,000 Capital stock $ $ Credit 100,000 5,000 32,000 Debit Adjusted Trial Balance 100,000 $ Credit Adjustments December 31, 20X6 Loans payable Unearned revenue 6,000 12,000 Accounts payable 15,000 Prepaid hangar rent $ 110,000 Accounts receivable Cash Trial Balance Clark Gliders Worksheet to Prepare Financial Statements Section 3.7 Reporting Periods and Worksheets CHAPTER 3 Exhibit 3.13: W \u0007 orksheet to prepare financial statements for Clark Gliders 8/29/12 2:43 PM CHAPTER 3 Section 3.7 Reporting Periods and Worksheets Closing can entail a series of journal entries to zero out the revenue accounts, the expense accounts, and the dividend accounts and then move their balances into retained earnings. Following is an example of the closing entries necessary for Clark Gliders. 12-31-X5 Revenues 146,000.00 Retained Earnings 146,000.00 To close revenues to retained earnings 12-31-X5 Retained Earnings 109,000.00 Flight Expense 60,000.00 Wages Expense 30,000.00 Depreciation Expense 9,000.00 Interest Expense 6,000.00 Rent Expense 4,000.00 To close all expense accounts to retained earnings 12-31-X5 Retained Earnings Dividends 6,000.00 6,000.00 To close dividends to retained earnings Notice that the preceding entries produced a net credit to Retained Earnings of $31,000 ($146,000 $109,000 $6,000), reflective of the periods increase in retained earnings. In other words, the firm's $37,000 of net income, less its $6,000 in dividends, resulted in the $31,000 increase in ending retained earnings. The closing process brings the firm's ledger fully up to date and sets the temporary accounts back to zero. Everything is now ready for the next accounting period to commence! The Asset, Liability, and Equity accounts are called real accounts because their balances are carried forward from period to period. Real accounts are not closed, and their balances carry forward into the future (e.g., cash does not go away just because a calendar page is flipped). Real accounts are also called permanent accounts and relate exclusively to items that appear on a balance sheet. Companies might prepare a post-closing trial balance (Exhibit 3.14) to reveal the balance of the real accounts following the closing process. Revenue, Expense, and Dividend accounts do not appear in the post-closing trial balance, given their zero balance. CHAPTER 3 Section 3.7 Reporting Periods and Worksheets Exhibit 3.14: The post-closing trial balance for Clark Gliders Clark Gliders Post-Closing Trial Balance December 31, 20X5 Debits Credits $ 110,000 15,000 8,000 90,000 Cash Accounts receivable Prepaid hangar rent Gliders Accumulated depreciation Accounts payable Unearned revenue Wages payable Interest payable Loans payable Capital stock Retained earnings - $ 223,000 9,000 $ 32,000 2,000 3,000 6,000 100,000 40,000 31,000 $ 223,000 Classified Balance Sheets You likely noticed that the balance sheet for Clark Gliders began to expand quickly to include more accounts. In an actual business setting, many more asset, liability, and even equity accounts can be introduced. To bring order to a report that could quickly become voluminous and disorganized, accountants have devised a somewhat standardized means of presentation called a classified balance sheet. Classified balance sheets include important groupings of accounts, usually listed in an expected order of appearance. The asset side of the balance sheet may include separate groups for the following: Current assets are items expected to be converted into cash or consumed within one year or the operating cycle, whichever is longer. The operating cycle (Exhibit 3.15) is the amount of time that a business needs to convert credit back into cash. For instance, a business may buy inventory, resell it on credit, and then eventually collect the resulting receivable. Exhibit 3.15: The operating cycle Cash Accounts Receivable waL80144_03_c03_053-088.indd 24 OPERATING CYCLE Inventory 8/29/12 2:43 PM Section 3.7 Reporting Periods and Worksheets CHAPTER 3 Specific current assets are customarily listed in order of liquidity (i.e., nearness to cash). Thus, cash is usually listed first, followed by receivables, inventory, and prepaid expenses. Long-term investments are items held for investment purposes, including shares of stock in other companies, idle land, cash surrender value of life insurance, and similar items. Property, plant, and equipment are items of land, buildings, and equipment that are used in production or services Intangible assets are items that lack physical existence but were purchased for the rights they convey. This list includes obvious assets like patents and copyrights but can also include brand names and more general business goodwill. Other assets are items that defy classification in one of the preceding categories, like selected long-term receivables. The liability side of the balance sheet may include separate groups for the following: Current liabilities are obligations that will likely be liquidated with current assets, typically within the next year or operating cycle, whichever is longer. Long-term liabilities are obligations that are not current, including bank loans and mortgages. The appearance of the equity section of the balance sheet depends on the nature of the business organization. Future chapters will cover unique equity elements related to sole proprietorships and partnerships. For now, we focus on the corporation, and stockholders' equity usually includes the following: Capital stock is the amount received from investors for company shares. The attributes of stock can become more complex and result in expanded presentations for issues such as preferred stock, common stock, paid-in capital in excess of par, and so on. (Future chapters introduce these additional details.) Retained earnings is the accumulated income less dividends. Exhibit 3.16 is an example of a classified balance sheet showing typical accounts and their manner of presentation. waL80144_03_c03_053-088.indd 25 8/29/12 2:43 PM CHAPTER 3 Section 3.7 Reporting Periods and Worksheets $ 780,000 $ 780,000 5,000 Total Stockholders' Equity Total Liabilities and Equity 115,000 Retained earnings Capital stock 100,000 Total Assets Receivable from employee Other Assets Patent (50,000) Less: Accumulated depreciation Intagible Assets $ 85,000 Building and equipment Land Property, Plant, & Equip. $ 100,000 35,000 135,000 Total Liabilites Stockholders' equity $ 250,000 365,000 $ 415,000 225,000 Cash value of insurance $ 90,000 Stock investments Long-term Investments 25,000 115,000 Mortgage liabity $ 100,000 Note payable Long-term Liabilities 15,000 45,000 180,000 Inventories Prepaid insurance 125,000 Accounts receivable Cash $ 75,000 $ 425,000 Current portion of note 7,000 Taxes payable 8,000 Interest payable Current liabilities Current Assets Accounts payable Liabilities Complex Company Balance Sheet December 31, 20X7 Assets $ 60,000 $ 325,000 90,000 Exhibit 3.16: A classified balance sheet Notes to the Financial Statements In addition to financial statements, companies are also expected to add notes to the statements that elaborate on account balance details and more. These notes describe key accounting policies, significant events, pending litigation, and similar details about the business. The principle of full disclosure dictates that financial statements and related notes are sufficient to allow financial statement users a legitimate basis for making informed judgments about the company. Exhibit 3.17 is a typical example of the notes you might encounter on a close review of financial statements. Some of these concepts will already appear familiar to you, and they will all make more sense by the end of this course. waL80144_03_c03_053-088.indd 26 8/29/12 2:43 PM Section 3.8 Cash Basis of Accounting CHAPTER 3 Exhibit 3.17: Notes that might be added to financial statements Use of Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Ultimate results could differ from those estimates. Fair Value The Company's cash, accounts receivable, other current assets, accounts payable, and certain accrued liabilities are carried at amounts which reasonably approximate their fair value due to their short-term nature. Inventories are stated at the lower of cost or market, valued on the first-in, first-out (\"FIFO\") method. Property, Plant, and Equipment is stated at cost and depreciated using the straight-line method over the estimated useful lives of the assets. Revenue Recognition is upon delivery of product to the Company's customer and collectability is reasonably assured. The Company's ordering process creates persuasive evidence of the sale arrangement and the sales amount is determined. The delivery of the goods to the customer completes the earnings process. Design, Research, and Development Costs are charged to selling, general, and administrative expense in the periods incurred. 3.8 Cash Basis of Accounting T he measurement, recording, and adjusting process presented thus far has relied on the accrual basis of accounting. The accrual basis is required under generally accepted accounting principles (GAAP). However, not all businesses necessarily apply GAAP. Small businesses that do not have an external user base (i.e., privately held companies without significant creditors) may be less concerned with particular details of how to measure income exactly correct for each period. They may be more interested in expediency and efficiency in the accounting process. Sometimes, these businesses will forgo GAAP and the accrual basis and opt for the much simpler cash basis of accounting. Although the cash basis is simpler to apply, it can result in misleading financial statements. With the cash basis, revenue is recorded as cash is received (regardless of when it is earned), and expenses are recorded concurrent with their payment. To illustrate, assume waL80144_03_c03_053-088.indd 27 8/29/12 2:43 PM CHAPTER 3 Concept Check that Tanner Company recently provided $5,000 of services on account, 60% of which has been collected. The company additionally received a $1,000 advance payment from a new customer for which work has yet to be performed and provided $10,000 of services for cash. On the cash basis, revenues would amount to $14,000 as follows: Collections of accounts ($5,000 3 60%) $ 3,000 Advance payment 1,000 Services rendered for cash 10,000 Total cash collections $14,000 This amount can be verified by checking deposits in Tanner's bank account. It is a simple matter to measure deposits. How much was Tanner's accrual basis revenue? It would be $15,000, representing the $5,000 of services rendered on account and the $10,000 of services rendered for cash. Sometimes accrual basis revenues are higher, sometimes lower, than cash basis revenues. In the long run, once all services have been provided and all cash collected, the two approaches should yield the same final outcome. Like revenues, expenses also differ between cash and accrual methods. Many companies use the cash basis of accounting for purposes of tax return preparation. By accelerating payments, expenses can be reported in an earlier time period. This results in lower income and therefore taxes for that period. Again, however, the long-run effects should work out the same. It is perfectly acceptable to have two sets of booksone for tax purposes and one for accounting purposesso long as the tax records comply with tax law. Tax accounting methods and approaches sometimes depart from the methods and approaches in use for financial accounting purposes. Concept Check The following questions relate to several issues raised in the chapter. Test your knowledge of the issues by selecting the best answer. (The answers appear on p. 235.) 1. The accrual basis of accounting a.\tis less popular than the cash basis with respect to use by large businesses. b.\tbetter matches expenses and revenues than does the cash basis of accounting. c. recognizes revenues when earned and expenses when paid. d.\trecognizes revenues when received and expenses when paid. 2. Joe \u0007 Hamilton contacted Denver Painting Contractors in July to paint his office building. The price was agreed on in August, the painting took place in September, and Hamilton paid Denver in October. In which month would Hamilton recognize an expense under the accrual basis of accounting? Under the cash basis of accounting? Accrual Basis a. July b. August c. September d. August waL80144_03_c03_053-088.indd 28 Cash Basis September September October October 8/29/12 2:43 PM CHAPTER 3 Key Terms 3. The \u0007 Supplies account of Design Limited contained a $3,200 balance before adjustment on December 31. If $2,400 worth of supplies remains on hand at year-end, what will be the proper adjusting entry? Debit Credit Amount Collections of accounts ($5,000 3 60%) Advance payment 1,000 10,000 Services rendered for cash Total cash collections a. b. c. d. Supplies Expense Supplies Expense Supplies Supplies $ 3,000 $14,000 Supplies Supplies Supplies Expense Supplies Expense $2,400 $ 800 $2,400 $ 800 4. Kip's \u0007 Appliances sells 3-month service contracts to buyers of new appliances. The $32,800 balance in the company's Unearned Service Contract Revenue account is properly classified as a. an expense. b. revenue. c. an asset. d. a liability. 5. As \u0007 of August 31, Sun Shade Auto Tinting owes $600 of interest (as yet unrecorded) to First Bank and Trust. If payment will take place on September 5, Sun Shade would classify the interest on August 31 as a. a prepaid expense. b. an unearned revenue. c. an accrued expense. d. an accrued revenue. Key Terms accounting cycle Key steps include examining source documents, recording transactions in the journal, posting journal entries to the indicated ledger accounts, perhaps constructing a trial balance, determining and posting adjusting entries, preparing an adjusted trial balance, and preparing financial statements from the adjusted trial balance. accrual basis The idea that transactions and events are to be measured based on their natural growth or increase, not their specific payment. waL80144_03_c03_053-088.indd 29 adjusting entries Journal entries that are necessary to cause asset, liability, revenue, expense, and all other accounts to contain their correct balance as of a particular reporting date. arm's length exchange transactions Exchange transactions that generally signify that independent buyers and sellers have agreed on the price for which goods are services are to be delivered. 8/29/12 2:43 PM Key Terms CHAPTER 3 calendar year A company's annual reporting period that follows the natural calendar and runs from January 1 to December 31. intermediate recognition An accounting model that records assets that have no future benefit and no discernible revenue. capital stock The amount of money received from investors for company shares. long-term investments Items held for investment purposes, including shares of stock in other companies, idle land, cash surrender value of life insurance, and similar items. cash basis Revenue that is recorded as cash is received (regardless of when earned) and expenses that are recorded concurrent with their payment. classified balance sheet Important groupings of accounts, usually listed in an expected order of appearance. contra asset an account related to an asset account, but that carries the opposite sign. Accumulated depreciation would be an example. current assets Items expected to be converted into cash or consumed within one year, or the operating cycle, whichever is longer. current liabilities Obligations that will likely be liquidated with current assets, typically within the next year or operating cycle, whichever is longer. depreciation The process by which the purchase of an asset is gradually transferred from a cost to an expense. fiscal year A reporting period that follows a natural business cycle rather than calendar year. historical cost principle Recording cost in a balance sheet according to its history rather than market value this cost is objec-tive and verifiable. intangible assets Items that lack physical existence but were purchased for the rights they convey and includes patents, copy-rights, brand names, and the more general business goodwill. waL80144_03_c03_053-088.indd 30 long-term liabilities Obligations that are not current, including bank loans and mortgages. matching principle The manner in which a large proportion of business costs are to be recorded. operating cycle The amount of time a business needs to convert credit back into cash. other assets Items that defy classification. periodicity assumption Business activity can be divided into specific time intervals, such as months, quarters, and years. post-closing trial balance Reveals the balance of the real accounts following the closing process. prepaid expenses Costs that are paid in advance. principle of full disclosure Dictates that financial statements and related notes are sufficient to allow financial statement users a legitimate basis for making informed judgments about the company. property, plant, and equipment Items of land, buildings, and equipment that are used in production or services. real accounts Asset, Liability, and Equity accounts that are not closed at the end of the accounting period. 8/29/12 2:43 PM Exercises revenue recognition The measurement of revenue that is synonymous with recording revenues into the accounts. systemic allocation An accounting model that systematically attributes some costs over time. CHAPTER 3 temporary accounts Revenue, Expense, and Dividend accounts that have been reset to a zero balance at the end of an accounting year, to be ready for the new accounting year. unearned revenue Amounts collected in advance of services being provided. Critical Thinking Questions 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. Differentiate between a fiscal year and a natural business year. When is revenue generally recognized in the accounting records? Explain the matching principle. What types of items frequently require adjusting entries? \u0007In reviewing the records of Yager Company, you find that 3 months' rent of $750 was prepaid to Savage Property Management on November 1. Both companies use the accrual basis of accounting. In view of this transaction, a.\t\u0007What account and amount would you show on Yager's income statement for the month ending November 30? On Savage's income statement for the month ending November 30? b.\t\u0007What account and amount would you show on Yager's November 30 balance sheet? On Savage's November 30 balance sheet? \u0007Why is the net income amount (as derived from the income statement columns of the worksheet) also entered as a credit in the balance sheet columns? What are the objectives of the closing process? What is meant by the term accounting cycle? Discuss the limitations of the balance sheet. What is an intangible asset? Give three examples of intangible assets. Exercises 1. \u0007Revenue and expense recognition, accrual basis. Dave Morris began a law practice several years ago, shortly after graduating from law school. During 20X1, he was approached by Delores Silva, who had recently suffered a back injury in an automobile accident. Morris accepted Silva as a client and in 20X2 proceeded with a lawsuit against Maddox Motors. The suit alleged that Maddox had knowingly sold Silva an automobile with defective brakes. Late in 20X2, the courts awarded Silva $240,000 in damages. Morris was entitled to 40% of this settlement for his fees. In 20X3, Maddox Motors paid Silva and Morris their respective shares of the judgment. Morris incurred secretarial and photocopy charges in 20X2 of $12,000all related to the Silva case. Of this amount, $8,000 was paid in 20X2 and the balance was paid in 20X3. Assuming that Morris uses the accrual basis of accounting, in what year(s) should the revenue and expense amounts be recognized? Why? waL80144_03_c03_053-088.indd 31 8/29/12 2:43 PM CHAPTER 3 Exercises 2. \u0007Recognition of concepts. Ron Carroll operates a small company that books entertainers for theaters, parties, conventions, and so forth. The company's fiscal year ends on June 30. Consider the following items and classify each as either (1) prepaid expense, (2) unearned revenue, (3) accrued expense, (4) accrued revenue, or (5) none of the foregoing. a.\tAmounts paid on June 30 for a 1-year insurance policy b.\tProfessional fees earned but not billed as of June 30 c.\tRepairs to the firm's copy machine, incurred and paid in June d.\tAn advance payment from a client for a performance next month at a convention e.\tThe payment in part (d) from the client's point of view f.\tInterest owed on the company's bank loan, to be paid in early July g.\tThe bank loan payable in part (f) h.\tOffice supplies on hand at year-end 3. \u0007Analysis of prepaid account balance. The following information relates to Action Sign Company for 20X2: Insurance expense $4,350 Prepaid insurance, December 31, 20X2 1,900 Cash outlays for insurance during 20X2 6,200 Compute the balance in the Prepaid Insurance account on January 1, 20X2. 4. \u0007Accounting for prepaid expenses and unearned revenues. Hawaii-Blue began business on January 1 of the current year and offers deep-sea fishing trips to tourists. Tourists pay $125 in advance for an all-day outing off the coast of Maui. The company collected monies during January for 210 outings, with 30 of the tourists not planning to take their trips until early February. Hawaii-Blue rents its fishing boat from Pacific Yacht Supply. An agreement was signed at the beginning of the year, and $72,000 was paid for the rights to use the boat for 2 full years. a.\t\u0007Prepare journal entries to record (1) the collection of monies from tourists and (2) the revenue generated during January. b.\t\u0007Calculate Hawaii-Blue's total obligation to tourists at the end of January. On what financial statement and in which section would this amount appear? c.\t\u0007Prepare journal entries to record (1) the payment to Pacific Yacht Supply and (2) the subsequent adjustment on January 31. d.\t\u0007On what financial statement would Hawaii-Blue's January boat rental cost appear? waL80144_03_c03_053-088.indd 32 8/29/12 2:43 PM CHAPTER 3 Exercises 5. \u0007Adjustment error. The accountant for Stringer Services failed to adjust the Supplies account to recognize the amount consumed during March. As a result of this error, will the following items be overstated, understated, or unaffected? a.\tMarch revenues will be ________________. b.\tMarch expenses will be ________________. c.\tMarch net income will be _______________. d.\tEnding owner's equity as of March 31 will be _________________. e.\tAssets as of March 31 will be __________________. f.\tLiabilities as of March 31 will be _________________. 6. \u0007Overview of the closing process. Evaluate the comments that follow as being true or false. If the comment is false, briefly explain why. a.\t\u0007The closing process is performed after adjusting entries have been journalized and posted. b.\t\u0007Because they both possess a debit balance, Salaries Expense and Susan Franklin, Drawing, are treated in the same manner when accounts are closed at the end of the period. c.\t\u0007The Equipment account