Libby Financial Accounting Chapter4

Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings

Chapter 04 Adjustments, Financial Statements, and the Quality of Earnings ANSWERS TO QUESTIONS 1. A trial balance is a list of the individual accounts, usually in financial statement order, with their debit or credit balances. It is used to provide a check on the equality of the debits and credits.

2. Adjusting entries are made at the end of the accounting period to record all revenues and expenses that have not been recorded but belong in the current period. They update the balance sheet and income statement accounts at the end of the accounting period.

3. The four different types are adjustments for: (1) Deferred revenues -- previously recorded liabilities that need to be adjusted at the end of the period to reflect revenues that have been earned (e.g., Unearned Ticket Revenue must be adjusted for the portion of ticket revenues earned in the current period). (2) Accrued revenues -- revenues that have been earned by the end of the accounting period but which will be collected in a future accounting period (e.g., recording Interest Receivable for interest revenues not yet collected). (3) Deferred expenses -- previously recorded assets that need to be adjusted at the end of the period to reflect incurred expenses (e.g., Prepaid Insurance must be adjusted for the portion of insurance expense incurred in the current period). (4) Accrued expenses -- expenses that have been incurred by the end of the accounting period but which will be paid in a future accounting period (e.g., recording Utilities Payable for utilities expense incurred during the period that has not yet been paid). 4. A contra-asset is an account related to an asset that is an offset or reduction to the asset's balance. Accumulated Depreciation is a contra-account to the equipment and buildings accounts.

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Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings

5. The net income on the income statement is included in determining ending retained earnings on the statement of stockholders’ equity and the balance sheet. The change in the cash account on the balance sheet is analyzed and categorized on the statement of cash flows into cash from operating activities, investing activities, and financing activities. 6. (a) Income statement: Revenues (and gains) - Expenses (and losses) = Net Income (b) Balance sheet: Assets = Liabilities + Stockholders' Equity (c) Statement of cash flows: Changes in cash for the period = Cash from Operations + Cash from Investing Activities + Cash from Financing Activities (d) Statement of stockholders' equity: Ending Stockholders' Equity = (Beginning Contributed Capital + Stock Issuances - Stock Repurchases) + (Beginning Retained Earnings + Net Income - Dividends Declared) 7. Adjusting entries have no effect on cash. For deferred revenues and deferred expenses, cash was received or paid at some point in the past. For accruals, cash will be received or paid in a future accounting period. At the time of the adjusting entry, there is no cash being received or paid. 8. Earnings per share = Net income ÷ average number of shares of stock outstanding during the period. Earnings per share measures the average amount of net income for the year attributable to one share of common stock. 9. Net profit margin = Net income ÷ net sales The net profit margin measures how much of every sales dollar generated during the period is profit. 10. An unadjusted trial balance is prepared after all current transactions have been journalized and posted to the ledger. It does not include the effects of the adjusting entries. The basic purpose of an unadjusted trial balance is to check the equalities of the accounting model (particularly, Debits = Credits) and to provide the data in a form convenient for further processing in the accounting information processing cycle. In contrast, an adjusted trial balance is prepared after the effects of all of the adjusting entries have been applied to the corresponding (prior) unadjusted trial balance amounts. The basic purpose of an adjusted trial balance is to insure that accuracy has been attained in applying the effect of the adjusting entries. The adjusted trial balance provides a second check in the model equalities (primarily Debits = Credits). It also provides data in a form convenient for further processing.

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Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings

11. The closing entry is made at the end of the accounting period to (1) transfer the balances in the temporary income statement accounts to retained earnings and (2) reduce the revenue, gain, expense, and loss accounts to a zero balance so that they can be used for the accumulation process during the next period. A closing entry must be entered into the system through the journal and posted to the ledger accounts to state properly the temporary and permanent account balances (i.e., zero balances in the temporary accounts). 12. (a) Permanent accounts -- balance sheet accounts; that is, the asset, liability, and stockholders’ equity accounts (these are not closed at the end of each period). (b) Temporary accounts -- income statement accounts; that is, revenues, gains, expenses, and losses (these are closed at the end of each period). (c) Real accounts -- another name for permanent accounts. (d) Nominal accounts -- another name for temporary accounts. 13. The income statement accounts are closed at the end of the accounting period because, in effect, they are temporary subaccounts to retained earnings (i.e., a part of stockholders' equity). They are used only for accumulation during the accounting period. When the period ends, these accumulated accounts must be transferred (closed) to retained earnings. The closing process serves: (1) to correctly state retained earnings, and (2) to clear out the balances of the temporary accounts for the year just ended so that these subaccounts can be used again during the next period for accumulation and classification purposes. Balance sheet accounts are not closed at the end of the period because they reflect permanent accumulated balances of assets, liabilities, and stockholders' equity. Permanent accounts show the entity's financial position at the end of the period and are the beginning amounts for the next period. 14. A post-closing trial balance is a listing taken from the ledger after the adjusting and closing entries have been journalized and posted. It is not a necessary part of the accounting information processing cycle but it is useful because it demonstrates the equality of the debits and credits in the ledger after the closing entry has been journalized and posted and that all temporary accounts have zero balances.

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Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings

ANSWERS TO MULTIPLE CHOICE 1. 2. 3. 4. 5. 6. 7. 8. 9. 10.

c b b a b c c d c a

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Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings

EXERCISES E4–2. Req. 1 Types Deferred Revenues: Deferred Revenue may need to be adjusted for any revenue earned during the period

Deferred Revenue (L) and Product Revenue and/or Service Revenue (R)

Accrued Revenues: Interest may be earned on Short-term Investments

Interest Receivable (A) and Interest Revenue (R)

Any unrecorded sales or services provided will need to be recorded Deferred Expenses: Other Current Assets may include supplies, prepaid rent, prepaid insurance, or prepaid advertising Any additional use of Property, Plant, and Equipment during the period will need to be recorded Accrued Expenses: Interest incurred on Short-term Note Payable and Long-term Debt will need to be recorded There are likely many other accrued expenses to be recorded, including wages, warranties, and utilities

Accounts to be Adjusted

Accounts Receivable (A) and Product Revenue and/or Service Revenue (R) Other Current Assets (A) and Selling, General, and Administrative Expense (E) Accumulated Depreciation (XA) and Cost of Products and/or Cost of Services (E)

Accrued Liabilities (L) and Interest Expense (E)

Accrued Liabilities (L) and Selling, General, and Administrative Expenses (among other expenses) (E)

Income taxes must be computed for the Income Tax Payable (L) and period and accrued Income Tax Expense (E) Req. 2 Temporary accounts that accumulate during the period are closed at the end of the year to the permanent account Retained Earnings. These include: Product revenue, service revenue, interest revenue, cost of products, cost of services, interest expense, research

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Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings

and development expense, selling, general, and administrative expense, other expenses, and income tax expense.

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Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings

E4–3. Req. 1 The annual reporting period for this company is January 1 through December 31, 2011.

Req. 2 (Adjusting entries) Both transactions are accruals because revenue has been earned and expenses incurred but no cash has yet been received or paid. (a) 1. Wages expense is incurred. 2. Cash will be paid in the next period to employees who worked in the current period – an accrued expense needs to be recorded. 3. Amount: $7,000 given Adjusting entry – Wages expense (+E, −SE)........................... Wages payable (+L)..............................

7,000

7,000

(b) 1. Interest revenue is now earned. 2. Cash will be received in the future – an accrued revenue needs to be recorded. 3. Amount: $2,000 given Adjusting entry – Interest receivable (+A) ............................... Interest revenue (+R, +SE)...................

2,000

2,000

Req. 3 Adjusting entries are necessary at the end of the accounting period to ensure that all revenues earned and expenses incurred and the related assets and liabilities are measured properly. The entries above are accruals; entry (a) is an accrued expense (incurred but not yet recorded) and entry (b) is an accrued revenue (earned but not yet recorded). In applying the accrual basis of accounting, revenues should be recognized when earned and measurable and expenses should be recognized when incurred in generating revenues.

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Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings

E4–4. Req. 1 Prepaid Insurance is a deferred expense that needs to be adjusted each period for the amount used during the period. The amount of expense is computed as follows: $3,600 x 3/24 = $450 used Adjusting entry: Insurance expense (+E, −SE)..................................... Prepaid insurance (−A) ....................................

450 450

Req. 2 Shipping Supplies is a deferred expense that needs to be adjusted at the end of the period for the amount of supplies used during the period. The amount is computed as follows: Beginning balance Supplies purchased Supplies on hand at end Supplies used Adjusting entry: Shipping supplies expense (+E, −SE) ........................ Shipping supplies (−A) .....................................

$11,000 60,000 (20,000) $51,000 51,000 51,000

Req. 3 Prepaid Insurance 10/1 3,600 AJE 450 End. 3,150

Insurance Expense AJE End.

Shipping Supplies Beg. 11,000

Purch. 60,000 AJE 51,000 End. 20,000

450 450

Shipping Supplies Expense

AJE 51,000

End. 51,000

2011 Income statement: Insurance expense $ 450 Shipping supplies expense $51,000

Req. 4 2011 Balance sheet: Prepaid insurance $ 3,150 Shipping supplies $20,000

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Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings

E4–5.

Transaction Assets NE E4–3 (a) +2,000 E4–3 (b) –450 E4–4 (a) –51,000 E4–4 (b)

Balance Sheet Stockholders’ Liabilities Equity +7,000 –7,000 NE +2,000 NE –450 NE –51,000

Income Statement Net Revenues Expenses Income NE +7,000 –7,000 +2,000 NE +2,000 NE +450 –450 NE +51,000 –51,000

E4–7. Req. 1 a. b. c. d. e. f. g.

Accrued revenue Deferred expense Accrued expense Deferred revenue Deferred expense Deferred expense Accrued expense

Req. 2 Accounts receivable (+A) ............................. 2,700 a. Service revenue (+R, +SE)................. b.

c.

d.

Advertising expense (+E, −SE)..................... Prepaid advertising (−A) .....................

2,700

900 900

Interest expense (+E, −SE) .......................... 5,000 Interest payable (+L) ..........................

Unearned storage revenue (−L) ................... Storage revenue (+R, +SE) ................

Computations Given

5,000

750 750

$1,200 x 9/12 = $900 used $250,000 x .12 x 2/12 (since last payment) = $5,000 incurred $4,500 x 1/6 = $750 earned

e.

Depreciation expense (+E, −SE) .................. 22,000 22,000 Accumulated depreciation (+XA, −A)

Given

f.

Supplies expense (+E, −SE)......................... 50,100 50,100 Supplies (−A) ......................................

$16,500 + $46,000 – $12,400 = $50,100 used

g.

Wages expense (+E, −SE) ........................... 3,800 Wages payable (+L) ...........................

Given

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Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings

E4–18. Req. 1 (a)

(b)

(c)

(d)

Insurance expense (+E, −SE) .................................... Prepaid insurance (−A) ....................................

4

Wages expense (+E, −SE) ......................................... Wages payable (+L).........................................

5

Depreciation expense (+E, −SE) ................................ Accumulated depreciation (+XA, −A) ...............

8

Income tax expense (+E, −SE)................................... Income tax payable (+L) ..................................

9

4

5

8

9

Req. 2 RED RIVER COMPANY Trial Balance December 31, 2011 (in thousands of dollars)

Account Titles Cash Accounts receivable Prepaid insurance Machinery Accumulated depreciation Accounts payable Wages payable Income taxes payable Contributed capital Retained earnings Revenues (not detailed) Expenses (not detailed)

Totals

Unadjusted Debit Credit 35 9 6 80

Adjustments Debit Credit

a 4 c 8

9 b 5 d 9 73 4 84 32

166

a c b d 166

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4 8 5 9 26

26

Adjusted Debit Credit 35 9 2 80 8 9 5 9 73 4 84 58

188

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Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings

PROBLEMS P4–1. Req. 1 Dell Inc.

Adjusted Trial Balance

At January 31, 2012

(in millions of dollars)

Debit Cash Marketable securities Accounts receivable Inventories Property, plant, and equipment Accumulated depreciation Other assets Accounts payable Accrued expenses payable Long-term debt Other liabilities Contributed capital Retained earnings (deficit) Sales revenue Other income Cost of sales Selling, general, and administrative expenses Research and development expense Income tax expense Totals

Credit $ 8,352 740 6,443 867 4,510 $ 2,233 7,821 8,309 3,788 1,898 8,234 11,189 9,396 61,101 134 50,144 7,102 665 846 $ 96,886

$ 96,886

Req. 2 Since debits are supposed to equal credits in a trial balance, the balance in Retained Earnings is determined as the amount in the debit column necessary to make debits equal credits (a “plugged” figure).

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Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings

P4–2. Req. 1 a.

Deferred revenue

e.

Deferred expense

b.

Accrued expense

f.

Accrued revenue

c.

Deferred expense

g.

Accrued expense

d.

Deferred revenue

h.

Accrued expense

Req. 2 a. Unearned rent revenue (−L)......................................... Rent revenue (+R, +SE)..................................... ($8,400 ÷ 6 months = $1,400 per month x 4 months)

5,600

b. Interest expense (+E, −SE) .......................................... Interest payable (+L) ............................................ ($18,000 x .12 x 3/12)

540

c. Depreciation expense (+E, −SE).................................. Accumulated depreciation (+XA, −A) ..................

2,500

d. Unearned service revenue (−L).................................... Service revenue (+R, +SE) ................................. ($3,000 x 2/12)

500

5,600

540

2,500

500

1,500 e. Insurance expense (+E, −SE) ...................................... Prepaid insurance (−A)...................................... ($9,000 ÷ 12 months = $750 per month x 2 months of coverage) f.

Accounts receivable (+A) ............................................. Service revenue (+R, +SE) ................................

4,000

g. Wage expense (+E, −SE)............................................. Wages payable (+L) ...........................................

14,000

h. Property tax expense (+E, −SE)................................... Property tax payable (+L).....................................

500

4-12

1,500

4,000

14,000

500