CHAPTER THE ADJUSTING PROCESS DISCUSSION QUESTIONS a Under cash-basis accounting, revenues are reported in the period in which cash is received and expenses are reported in the period in which cash is paid b Under accrual-basis accounting, revenues are reported in the period in which they are earned and expenses are reported in the same period as the revenues to which they relate The matching concept is related to the accrual basis of accounting Adjusting entries are necessary at the end of an accounting period to bring the ledger up to date Adjusting entries bring the ledger up to date as a normal part of the accounting cycle Correcting entries correct errors in the ledger Four different categories of adjusting entries include prepaid expenses (deferred expenses), unearned revenues (deferred revenues), accrued expenses (accrued liabilities), and accrued revenues (accrued assets) Statement (a): Increases the balance of a revenue account Statement (b): Increases the balance of an expense account Yes, because every adjusting entry affects expenses or revenues a The rights acquired represent an asset b The justification for debiting Rent Expense is that when the ledger is summarized in a trial balance at the end of the month and statements are prepared, the rent will have become an expense Hence, no adjusting entry will be necessary a The portion of the cost of a fixed asset deducted from revenue of the period is debited to Depreciation Expense It is the expired cost for the period The reduction in the fixed asset account is recorded by a credit to Accumulated Depreciation rather than to the fixed asset account The use of the contra asset account facilitates the presentation of original cost and accumulated depreciation on the balance sheet b Depreciation Expense—debit balance; Accumulated Depreciation—credit balance c No, it is not customary for the balances of the two accounts to be equal in amount d Depreciation Expense appears on the income statement; Accumulated Depreciation appears on the balance sheet 10 3-1 © 2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part CHAPTER The Adjusting Process PRACTICE EXERCISES PE 3–1A a b Yes No c d No Yes e f Yes Yes c d Yes No e f No Yes PE 3–1B a b No No PE 3–2A a b Unearned revenue Prepaid expense c d Accrued revenue Accrued expense c d Accrued expense Prepaid expense PE 3–2B a b Unearned revenue Accrued revenue PE 3–3A Supplies Expense Supplies Supplies used ($1,975 + $4,125 – $1,850) 4,250 4,250 PE 3–3B Insurance Expense Prepaid Insurance Insurance expired ($9,600 + $12,900 – $7,360) 15,140 15,140 PE 3–4A Unearned Fees Fees Earned Fees earned ($78,500 – $33,675) 44,825 44,825 PE 3–4B Unearned Rent Rent Revenue Rent earned [($18,900 ÷ 12 months) × months] 11,025 11,025 PE 3–5A Accounts Receivable Fees Earned Accrued fees 12,840 12,840 PE 3–5B Accounts Receivable Fees Earned Accrued fees 17,555 17,555 PE 3–6A Salaries Expense Salaries Payable Accrued salaries [($16,250 ữ days) ì days] 9,750 9,750 PE 3–6B Salaries Expense Salaries Payable Accrued salaries [($27,600 ữ days) ì days] 23,000 23,000 PE 3–7A Depreciation Expense Accumulated Depreciation—Equipment Depreciation on equipment 9,100 9,100 PE 3–7B Depreciation Expense Accumulated Depreciation—Equipment Depreciation on equipment 7,700 7,700 PE 3–8A a b c Revenues were understated by $44,500 Expenses were understated by $13,100 ($5,800 + $7,300) Net income was understated by $31,400 ($44,500 – $13,100) PE 3–8B a b c Revenues were understated by $6,600 Expenses were understated by $10,400 ($1,400 + $9,000) Net income was overstated by $3,800 ($10,400 – $6,600) PE 3–9A a b The totals are unequal The debit total is higher by $900 ($9,800 – $8,900) The totals are equal, since the adjusting entry was omitted PE 3–9B a The totals are equal even though the credit should have been to Wages Payable instead of Accounts Payable b The totals are unequal The credit total is higher by $27 ($1,152 – $1,125) PE 3–10A HEMLOCK COMPANY Income Statements For Years Ended December 31 a 2014 Amount Fees earned Operating expenses Operating income b 2013 Percent $725,000 435,000 $290,000 100% 60% 40% Amount Percent $615,000 356,700 $258,300 100% 58% 42% An unfavorable trend of increasing operating expenses and decreasing operating income is indicated PE 3–10B CORNEA COMPANY Income Statements For Years Ended December 31 a 2014 Amount Fees earned Operating expenses Operating income b $1,640,000 869,200 $ 770,800 2013 Percent 100% 53% 47% Amount $1,300,000 715,000 $ 585,000 A favorable trend of decreasing operating expenses and increasing operating income is indicated Percent 100% 55% 45% EXERCISES Ex 3–1 Prepaid expense Accrued revenue Unearned revenue Accrued expense Ex 3–2 Account Accounts Receivable Cash Interest Expense Interest Receivable Johann Atkins, Capital Land Office Equipment Prepaid Rent Supplies Unearned Fees Wages Expense Unearned revenue Prepaid expense Accrued expense Accrued expense Answer Normally requires adjustment (AR) Does not normally require adjustment Normally requires adjustment (AE) Normally requires adjustment (AR) Does not normally require adjustment Does not normally require adjustment Does not normally require adjustment Normally requires adjustment (PE) Normally requires adjustment (PE) Normally requires adjustment (UR) Normally requires adjustment (AE) Ex 3–3 Supplies Expense Supplies Supplies used ($2,389 – $830) 1,559 Ex 3–4 $5,810 ($1,560 + $4,250) Ex 3–5 a Insurance expense (or expenses) will be understated Net income will be overstated b Prepaid insurance (or assets) will be overstated Owner’s equity will be overstated 1,559 Ex 3–6 a b Insurance Expense Prepaid Insurance Insurance expired 16,450 Insurance Expense Prepaid Insurance Insurance expired ($21,700 – $5,250) 16,450 16,450 16,450 Ex 3–7 a b Insurance Expense Prepaid Insurance Insurance expired ($12,000 + $18,000 – $13,600) 16,400 Insurance Expense Prepaid Insurance Insurance expired 16,400 16,400 16,400 Ex 3–8 Unearned Fees Fees Earned Fees earned ($37,500 – $12,300) 25,200 25,200 Ex 3–9 a Rent revenue (or revenues) will be understated Net income will be understated b Unearned rent (liabilities) will be overstated Owner’s equity at the end of the period will be understated Ex 3–10 a b Accounts Receivable Fees Earned Accrued fees 8,450 No If the cash basis of accounting is used, revenues are recognized only when the cash is received Therefore, earned but unbilled revenues would not be recognized in the accounts, and no adjusting entry would be necessary 8,450 Ex 3–11 a b Unearned Fees Fees Earned Unearned fees earned during year 71,600 Accounts Receivable Fees Earned Accrued fees earned 47,400 71,600 47,400 Ex 3–12 a Fees earned (or revenues) will be understated Net income will be understated b Accounts (fees) receivable (or assets) will be understated Owner’s equity will be understated Ex 3–13 a b Salaries Expense Salaries Payable Accrued salaries [($11,750 ữ days) ì days] 7,050 Salaries Expense Salaries Payable Accrued salaries [($11,750 ÷ days) × days] 9,400 7,050 9,400 Ex 3–14 $66,075 ($73,250 – $7,175) Ex 3–15 a Salary expense (or expenses) will be understated Net income will be overstated b Salaries payable (or liabilities) will be understated Owner’s equity will be overstated Ex 3–16 a Salary expense (or expenses) will be overstated Net income will be understated b The balance sheet will be correct This is because salaries payable has been satisfied, and the net income errors have offset each other Thus, owner’s equity is correct Ex 3–17 a b Taxes Expense Prepaid Taxes Prepaid taxes expired [($28,800 ÷ 12 months) × months] Taxes Expense Taxes Payable Accrued taxes 21,600 21,600 49,800 49,800 $71,400 ($21,600 + $49,800) Ex 3–18 Depreciation Expense Accumulated Depreciation—Equipment Depreciation on equipment 6,760 Ex 3–19 a $650,000 ($1,375,000 – $725,000) b No Depreciation is an allocation of the cost of the equipment to the periods benefiting from its use It does not necessarily relate to value or loss of value Ex 3–20 a $7,630 million ($16,259 – $8,629) b No Depreciation is an allocation method, not a valuation method That is, depreciation allocates the cost of a fixed asset over its useful life Depreciation does not attempt to measure market values, which may vary significantly from year to year Ex 3–21 Income: $3,947 million ($2,054 + $1,893) Ex 3–22 a $560 million b 45.1% ($560 ÷ $1,242) 6,760 Ex 3–23 Revenue for the year would be……………… Expenses for the year would be…………… Net income for the year would be………… Assets at August 31 would be……………… Liabilities at August 31 would be…………… Owner’s equity at August 31 would be…… Error (a) OverUnderstated stated $ $23,250 0 23,250 0 23,250 0 23,250 Error (b) OverUnderstated stated $ $ 0 4,000 4,000 0 0 4,000 4,000 Ex 3–24 $132,900 ($113,650 + $23,250 – $4,000) Ex 3–25 Depreciation Expense Accumulated Depreciation—Equipment Depreciation on equipment a b 13,900 (1) Depreciation expense would be understated Net income would be overstated (2) Accumulated depreciation would be understated, and total assets would be overstated Owner’s equity would be overstated 13,900 Prob 3–5B (Concluded) REECE FINANCIAL SERVICES CO Adjusted Trial Balance July 31, 2014 Debit Balances Cash Accounts Receivable Prepaid Insurance Supplies Land Building Accumulated Depreciation—Building Equipment Accumulated Depreciation—Equipment Accounts Payable Unearned Rent Salaries and Wages Payable Joni Reece, Capital Joni Reece, Drawing Fees Earned Rent Revenue Salaries and Wages Expense Utilities Expense Advertising Expense Depreciation Expense—Building Repairs Expense Insurance Expense Depreciation Expense—Equipment Supplies Expense Miscellaneous Expense Credit Balances 10,200 44,950 1,500 615 50,000 155,750 69,250 45,000 20,450 3,750 300 900 153,550 8,000 168,800 3,300 57,750 14,100 7,500 6,400 6,100 4,500 2,800 1,110 4,025 420,300 420,300 Prob 3–6B b c d a Accounts Receivable Fees Earned Accrued fees earned 31,900 31,900 Depreciation Expense Accumulated Depreciation—Equipment Equipment depreciation 7,500 Wages Expense Wages Payable Accrued wages 5,200 Supplies Expense Supplies Supplies used 3,000 7,500 5,200 3,000 Net Income Reported amounts Corrections: Adjustment (a) Adjustment (b) Adjustment (c) Adjustment (d) Corrected amounts Total Assets = Total Liabilities + Total Owner's Equity $112,500 $650,000 $225,000 $425,000 +31,900 –7,500 –5,200 –3,000 +31,900 –7,500 –3,000 0 +5,200 +31,900 –7,500 –5,200 –3,000 $128,700 $671,400 $230,200 $441,200 CONTINUING PROBLEM Date 2014 July Description Adjusting Entries 31 Accounts Receivable Fees Earned Accrued fees earned (115 hrs – 80 hrs.) × $40 = $1,400 Page JOURNAL Post Ref Debit Credit 12 41 1,400 31 Supplies Expense Supplies Supplies used ($1,020 – $275) 56 14 745 31 Insurance Expense Prepaid Insurance Insurance expired ($2,700 ÷ 12 months) = $225 per month 57 15 225 31 Depreciation Expense Accum Depr.—Office Equipment Office equipment depreciation 58 18 50 31 Unearned Revenue Fees Earned Fees earned ($7,200 ÷ months) 23 41 3,600 31 Wages Expense Wages Payable Accrued wages 50 22 140 1,400 745 225 50 3,600 140 Continuing Problem (Continued) Account: Post Date 2014 July Account: 11 Account No Cash Item Balance 1 3 11 13 14 16 21 22 23 27 28 29 30 31 31 31 Accounts Receivable Ref √ 1 1 1 1 1 2 2 2 2 2 Balance Debit Credit 5,000 1,750 2,700 1,000 7,200 250 900 200 1,000 700 1,200 2,000 620 800 750 915 1,200 540 500 3,000 1,400 1,250 Debit Credit 3,920 8,920 7,170 4,470 5,470 12,670 12,420 11,520 11,320 12,320 11,620 10,420 12,420 11,800 11,000 11,750 10,835 9,635 9,095 9,595 12,595 11,195 9,945 Account No 12 Post Date 2014 July Item Balance 23 30 31 Adjusting Ref √ 2 Balance Debit Credit 1,000 1,750 1,000 1,400 Debit 1,000 — 1,750 2,750 4,150 Credit — Continuing Problem (Continued) Balance Post Date 2014 July Item Balance 18 31 Adjusting Ref √ Debit Debit Credit 850 745 170 1,020 275 2014 July Item 31 Adjusting Ref Debit Credit Debit 2,700 225 Office Equipment Account: 2014 July Account: Item Ref Balance Debit Debit Credit 7,500 2014 July Account: 31 Adjusting Balance Debit Credit Debit 50 2014 July Account: Balance 18 Ref √ 1 Balance Debit Credit 250 Debit 2014 July 31 Adjusting 250 — 7,500 8,350 7,500 850 Wages Payable Item Credit — 22 Account No Post Date 21 Account No Post Item Credit 50 Accounts Payable Date 18 Account No Post Ref Credit 7,500 Accumulated Depreciation—Office Equipment Item 17 Account No Date Credit 2,700 2,475 Post Date 15 Balance Post Date Credit Account No Prepaid Insurance Account: 14 Account No Supplies Account: Ref Balance Debit Credit 140 Debit Credit 140 CHAPTER The Adjusting Process Continuing Problem (Continued) Account: Unearned Revenue Post Date 2014 July Account: Ref Item 31 Adjusting Balance Debit Credit Debit 7,200 3,600 3,600 Account: Ref Item Balance Balance Debit √ Credit Debit 4,000 9,000 2014 July Account: Date Balance 31 Ref √ Balance Debit Credit Debit Credit 500 1,750 1,250 Income Summary Item 32 Account No Post Item Credit 5,000 Peyton Smith, Drawing Date 31 Account No Post 2014 July Credit 7,200 Peyton Smith, Capital Date 23 Account No 33 Account No Post Ref Debit Credit Debit Balance Credit (This account is not used in Chapter 3.) Account: Fees Earned Post Date 2014 July Item Balance 11 16 23 30 31 31 Adjusting 31 Adjusting 41 Account No Ref √ 2 2 3 Balance Debit Credit 1,000 2,000 2,500 1,500 3,000 1,400 3,600 Debit Credit 6,200 7,200 9,200 11,700 13,200 16,200 17,600 21,200 CHAPTER The Adjusting Process Continuing Problem (Continued) Account: Wages Expense Post Date 2014 July Account: Item Balance 14 28 31 Adjusting Ref √ Balance Debit Credit Debit 1,200 1,200 140 Office Rent Expense Date Account: Item Balance Ref √ Balance Debit Credit Debit 2014 July Account: Balance 13 Ref √ 1,750 Balance Debit Credit Debit 2014 July Account: Balance 27 700 Ref √ Balance Debit Credit Debit 2014 July Balance 21 31 Credit 300 1,215 915 54 Account No Post Item 53 Account No Music Expense Date Credit 675 1,375 Post Item 52 Account No Utilities Expense Date Credit 800 2,550 Post Item 51 Account No Equipment Rent Expense Date Credit 400 1,600 2,800 2,940 Post 2014 July 50 Account No Ref √ 2 Balance Debit 620 1,400 Credit Debit 1,590 2,210 3,610 Credit CHAPTER The Adjusting Process Continuing Problem (Continued) Account: Post Date 2014 July Account: Item Ref Balance 22 √ Balance Debit Credit Debit 200 800 Supplies Expense 2014 July Account: Item Ref Balance 31 Adjusting √ Balance Debit Credit Debit 2014 July Account: Ref 31 Adjusting Balance Debit Credit 225 2014 July Account: Debit Credit 225 Depreciation Expense Item 57 Account No Account No Post Date Credit 180 925 745 Insurance Expense Item 56 Account No Post Date Credit 500 700 1,500 Post Date 55 Account No Advertising Expense Ref 31 Adjusting Miscellaneous Expense Debit Credit 50 58 Balance Debit Credit 50 Account No 59 CHAPTER The Adjusting Process Post Item Date 2014 July Balance 29 Ref √ Balance Debit 900 540 Credit Debit 415 1,315 1,855 Credit Continuing Problem (Concluded) PS MUSIC Adjusted Trial Balance July 31, 2014 Debit Balances Cash Accounts Receivable Supplies Prepaid Insurance Office Equipment Accumulated Depreciation—Office Equipment Accounts Payable Wages Payable Unearned Revenue Peyton Smith, Capital Peyton Smith, Drawing Fees Earned Music Expense Wages Expense Office Rent Expense Advertising Expense Equipment Rent Expense Utilities Expense Supplies Expense Insurance Expense Depreciation Expense Miscellaneous Expense Credit Balances 9,945 4,150 275 2,475 7,500 50 8,350 140 3,600 9,000 1,750 21,200 3,610 2,940 2,550 1,500 1,375 1,215 925 225 50 1,855 42,340 42,340 CASES & PROJECTS CP 3–1 It is acceptable for Daryl to prepare the financial statements for Squid Realty Co on an accrual basis The revision of the financial statements to include the accrual of the $30,000 commission as of December 28, 2013, would not be appropriate Most real estate contracts include contingencies that can void the contract Such contingencies include obtaining a loan, appraisals, environmental studies, and inspection results In other words, Daryl can only be sure of earning the commission on January 5, 2014, when the attorney formally records the transfer of the property to the buyer, and Daryl may disclose the pending sale and related commission in a note to the financial statements Indicating on the loan application to Free Spirit Bank that Squid Realty Co has not been rejected previously for credit is unethical and unprofessional, and intentionally filing false loan documents is illegal CP 3–2 The cost of the warranty repairs, $1,650, should be recognized as an expense of 2014 in order to properly match revenues from the sale of the truck with the related expenses Since the cost of the actual repairs will not be known at the time of sale (2014), Ford Motor Company would estimate warranty costs and expenses at the end of 2014 using its past warranty (repair) history with the Ford 350F This estimate would be recorded in the accounts through use of an adjusting entry The adjusting entry would debit Warranty Expense and credit Estimated Warranty Payable, a liability account CP 3–3 Revenue is normally recorded when the services are provided or when the goods are delivered (title passes) to the buyer By waiting until after the services are provided, the expenses of providing the services can be more accurately measured and matched against the related revenues Also, at this point, the provider of the services has a right to demand payment for the services if payment hasn’t already been received Airlines, such as Delta Air Lines, normally record revenue from ticket sales after completing a flight At this point, the boarding passes, which have been collected from the passengers, represent revenue to the airline In addition, the expenses related to each flight, such as landing fees and fuel, would have been incurred and would be accurately measured Note to Instructors: The following points might also be worth discussing: (1) The receipt of revenue from customers in advance of a flight represents unearned revenues to the airline For example, the purchase of discount tickets, which often requires prepayment months in advance of the actual flight, is unearned revenue to the airline (2) At the end of the airline’s accounting period, it would have adjusting entries related to such items as the following: ● Accrued wages for employees ● Depreciation on airplanes, terminal buildings, etc ● Unearned revenues (described above) ● Accrued income from transporting freight, etc ● Accrued income from other airlines (When a flight is delayed or canceled, airlines often accept passengers from other airlines and then later collect the revenue from the other airline.) ● Prepaid expenses related to insurance, etc CP 3–4 a b There are several indications that adjusting entries were not recorded before the financial statements were prepared, including: All expenses on the income statement are identified as “paid” items and not as “expenses.” No expense is reported on the income statement for depreciation, and no accumulated depreciation is reported on the balance sheet No supplies, accounts payable, or wages payable are reported on the balance sheet Likely accounts requiring adjustment include: Accumulated Depreciation—Truck for depreciation expense Supplies (paid) expense for supplies on hand Insurance (paid) expense for unexpired insurance Wages accrued Utilities accrued CP 3–5 Note to Instructors: The purpose of this activity is to familiarize students with behaviors that are common in codes of conduct In addition, this activity addresses an actual ethical dilemma for students related to doing their homework Consider asking students to look up your school’s Student Code of Conduct and discuss its implications for the behaviors described in this case An excerpt from one such Honor Code is shown below Students must share the responsibility for creating and maintaining an atmosphere of honesty and integrity Students should be aware that personal experience in completing assigned work is essential to learning Permitting others to prepare their work, using published or unpublished summaries as a substitute for studying required materials, or giving or receiving unauthorized assistance in the preparation of work to be submitted are directly contrary to the honest process of learning Students who are aware that others in a course are cheating or otherwise acting dishonestly have the responsibility to inform the professor and/or bring an accusation to the Honor Council http://smu.edu/studentlife/studenthandbook/pcl_05_hc.asp Southern Methodist University, The Honor Code, http://smu.edu/studentlife/studenthandbook .. .CHAPTER The Adjusting Process PRACTICE EXERCISES PE 3–1A a b Yes No c d No Yes e f Yes Yes c d Yes... understated Ex 3–10 a b Accounts Receivable Fees Earned Accrued fees 8,450 No If the cash basis of accounting is used, revenues are recognized only when the cash is received Therefore, earned but... (HP) Amount Net sales Cost of goods sold Operating expenses Operating income (loss) c Percent $126 ,033 (96,089) (18,465) $ 11,479 Percent 100.0% 76.2% 14.7% 9.1% Hewlett-Packard (HP) is more profitable