Module 3: Adjusting the accounts, preparing the statements, and completing the accounting cycle

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1 Page 1 of 27 Module 3: Adjusting the accounts, preparing the statements, and completing the accounting cycle Overview In Module 2 you studied the fundamental steps in recording accounting information by preparing the trial balance. This module takes you through the additional steps required to prepare proper financial statements and to complete the accounting cycle. You should focus on both the how and the why as you study each step. Test your knowledge Begin your work on this module with a set of test-your-knowledge questions designed to help you gauge the depth of study required. Learning objectives 3.1 Explain the need for financial statements and account adjustments at the end of regular accounting periods, and the purpose of the accrual basis of accounting. (Level 1) 3.2 Prepare adjusting entries for prepaid expenses, amortization, unearned revenues, accrued expenses, and accrued revenues. (Level 1) 3.3 Prepare an adjusted trial balance, and use it to prepare financial statements. (Level 1) 3.4 Prepare financial statements for a service business from the information in a work sheet. (Level 2) 3.5 Prepare closing entries for a service business. (Level 1) 3.6 Prepare a post-closing trial balance. (Level 1) 3.7 Review the steps in the accounting cycle. (Level 1) 3.8 Prepare a classified balance sheet. (Level 1) 3.9 Calculate the current ratio and explain its meaning. (Level 2) Module 3: Adjusting the accounts, preparing the statements, and completing the accounting cycle - Content Links

2 Page 2 of 27 Module 3 Test your knowledge a. If an accountant forgot to record amortization on office equipment at the end of an accounting period, which of the following would be true regarding the statements prepared at that time? 1. The assets are overstated and owner s equity is understated. 2. The assets and owner s equity are both understated. 3. The assets are overstated, net income is understated, and owner s equity is overstated. 4. The assets, net income, and owner s equity are overstated. b. The Crimson Cartage Company purchased a new truck at a cost of $42,000 on July 1, The truck is estimated to have a useful life of six years and a salvage value of $6,000. How much amortization expense will be recorded for the truck during the year ended December 31, 2006, assuming the straight-line method? 1. $3, $3, $4, $6,000 c. If accrued salaries were recorded on December 31 with a credit to Salaries payable, what would the entry to record payment of these salaries on January 5 include? 1. A debit to Cash and a credit to Salaries payable 2. A debit to Cash and a credit to Prepaid salaries 3. A debit to Salaries payable and a credit to Cash 4. A debit to Salaries payable and a credit to Salaries expense d. On the worksheet, the income statement debit column shows a total of $56,500. The income statement credit column total is $52,500. What is the net income or net loss? 1. The net loss of this business is $3, The net loss of this business is $4, The net income of this business is $4, The net income of this business is $5,000. e. An error is indicated if which of the following accounts has a balance appearing on the post-closing trial balance? 1. Office equipment 2. Accumulated amortization, office equipment 3. Amortization expense, office equipment 4. Ted Nash, capital Solutions Module 3 Test Your Knowledge solutions a. 1. Incorrect. The entry to record amortization includes a debit to an expense account. If this debit is not recorded, then net income on the income statement will be overstated (too high). If net income is overstated, then, on the balance sheet, equity is also overstated since net income

3 Page 3 of 27 affects equity. If the credit entry to Accumulated amortization is not recorded, assets will be overstated on the balance sheet. 2. Incorrect. The entry to record amortization includes a debit to an expense account. If this debit is not recorded, then net income on the income statement will be overstated (too high). If net income is overstated, then, on the balance sheet, equity is also overstated since net income affects equity. If the credit entry to Accumulated amortization is not recorded, assets will be overstated on the balance sheet. 3. Incorrect. The entry to record amortization includes a debit to an expense account. If this debit is not recorded, then net income on the income statement will be overstated (too high). If net income is overstated, then, on the balance sheet, equity is also overstated since net income affects equity. If the credit entry to Accumulated amortization is not recorded, assets will be overstated on the balance sheet. 4. Correct. The entry to record amortization includes a debit to an expense account. If this debit is not recorded, then net income on the income statement will be overstated (too high). If net income is overstated, then, on the balance sheet, equity is also overstated since net income affects equity. If the credit entry to Accumulated amortization is not recorded, assets will be overstated on the balance sheet. b. 1. Correct. ($42,000 $6,000) 6 years = $6,000 per year. $3,000 of amortization expense will be recorded for the truck during the year ended December 31, 2006 because the truck was purchased on July 1, 2006, resulting in a partial period of amortization ($6,000 per year 6/12 = $3,000). 2. Incorrect. $42,000 6 years 6/12 = $3,500; this calculation neglected to account for the salvage value. 3. Incorrect. Salvage value is subtracted and not added to determine the net cost of the asset that must be amortized. 4. Incorrect. $6,000 represents amortization for a full year; amortization needs to be recorded from July 1 to December 31, which is six months. c. 1. Incorrect. A debit to Cash means cash is being received, which is not correct. A credit to Salaries payable implies salaries are being accrued; salaries are actually being paid on January 5, not accrued. 2. Incorrect. A debit to Cash means cash is being received, which is not correct. A credit to Prepaid salaries implies an asset is decreasing; the only asset decreasing on January 5 is Cash. 3. Correct. The full entry on January 5 would be: Salaries payable... XX Salaries expense... XX Cash... XX 4. Incorrect. A debit to Salaries payable is correct. However, the credit to Salaries expense means expenses are being reduced, which is incorrect.

4 Page 4 of 27 d. 1. Incorrect. The difference between income statement columns on the worksheet is a net loss because expenses (debits) are greater than revenues (credits). However, the loss is equal to the difference of $4, Correct. The net loss of this business is $4,000, calculated as $56,500 less $52,500. Since the debits (expenses) are greater than the credits (revenues), the $4,000 difference represents a net loss. 3. Incorrect. The credit column of the income statement represents revenues and the debit column is expenses; therefore, since revenues are less than expenses, the difference of $4,000 cannot be a net income. 4. Incorrect. The credit column of the income statement represents revenues and the debit column is expenses; therefore, since revenues are less than expenses, the difference cannot be a net income. Moreover, the difference is $4,000. e. 1. Incorrect. Office equipment is an asset account. The post-closing trial balance includes assets because they are permanent accounts. 2. Incorrect. Accumulated amortization, office equipment, is a contra-asset account. The postclosing trial balance includes contra-assets because they are permanent accounts. 3. Correct. Amortization expense, office equipment, should not be included on the post-closing trial balance because expenses are temporary accounts, which are closed into Capital. If Amortization expense, office equipment, appears on the post-closing trial balance, then it was not closed properly during the closing process. 4. Incorrect. Ted Nash, capital, is an equity account, which is a permanent account included on the post-closing trial balance. 3.1 Time period principle and the need for adjustments Learning objective Explain the need for financial statements and account adjustments at the end of regular accounting periods, and the purpose of the accrual basis of accounting. (Level 1) Required reading Chapter 4, pages LEVEL 1 Net income over the entire life of a business is relatively easy to measure. If you started a painting business in May and dissolved it in August, for example, net income would be the difference between the revenues

5 Page 5 of 27 collected and the expenses paid out. Most businesses, however, operate over many years. In fact, the goingconcern principle assumes that a business will continue for an indefinite period. This leads to the need for information about the business resources and its performance during specific periods. The life of a business is divided into different periods, called accounting periods, for the purpose of preparing periodic financial statements. As a result, the time period principle has important implications in the practice of accounting. Time period principle The life of a business is arbitrarily divided into time periods of equal lengths to ensure that the users of financial statements receive timely information. The application of the time period principle normally results in financial statements being prepared on an annual basis. While not required by GAAP, most businesses choose to prepare interim financial reports on a monthly or quarterly basis as well so they can monitor their performance on an ongoing basis. Need for adjustments at the end of an accounting period Due to the passage of time and the manner in which a business records transactions in the normal course, the balances of some accounts appearing on the unadjusted trial balance presented in Module 2 may not be current. Adjusting entries are required to bring a firm s records up-to-date so that its financial statements fairly represent its economic activity. Textbook activity Flashback questions 1-4 on page Adjusting the accounts Learning objective Prepare adjusting entries for prepaid expenses, amortization, unearned revenues, accrued expenses, and accrued revenues. (Level 1) Required reading Chapter 4, pages Appendix 4B, pages LEVEL 1 Five types of adjustments are presented in the text prepaid expenses, amortization, unearned revenues, accrued expenses, and accrued revenues. Each adjustment affects both the balance sheet and income statement. It is important that you master these adjustments, so work through the examples in this topic and those in the text carefully.

6 Page 6 of 27 Prepaid expenses A prepaid expense is an economic benefit that has been paid for in advance of its use. There are two methods of recording prepaid expenses. The first, which is covered in Chapter 4, is the asset method. The concept behind the asset method is that the related expenditures are initially recorded as an asset and then subsequently charged to expense as the asset is consumed. This is the method that you are most likely to see in practice. Some companies, however, initially record all prepayments as expenses. If there is any asset remaining at the end of the accounting period, then an adjusting entry is passed to reflect this. This manner of treatment is known as the expense method, which is covered in Appendix 4B on pages Note that the asset recorded on your balance sheet and the amount charged to expense for the period will be the same, irrespective of the method chosen. This outcome serves to highlight an important point. Specifically, on a day-to-day basis, a company can record entries in any manner it chooses, as GAAP do not specify a firm's method of bookkeeping. In preparing the year-end financial statements, however, a company must prepare the necessary adjustments to ensure that they comply with GAAP. Amortization Amortization is an accounting term used in conjunction with the process of assigning the cost of capital assets (for example, equipment and buildings) to the periods that they contribute to the firm s revenues. It is important to note that amortization is a method of cost allocation, not asset valuation. A capital asset whose market value is increasing is still amortized because while the asset generates revenues, it gradually wears out. (An exception is land, which is never amortized because it lasts forever.) To match the expense of the asset to the revenues it is generating, the cost of the asset must be spread over its useful life as an expense. Textbook activity Judgement Call on page 145 Unearned revenues Unearned revenue (also called deposits or deferred revenue) is a liability account. The balance represents payment received in advance for goods or services that have not yet been provided. For example, a magazine may sell a one-year subscription to a subscriber, collecting money in advance. Cash is debited to record the amount received, while unearned revenue is credited in a corresponding amount to reflect the downstream obligation to provide the magazines. Unearned revenue is earned when the goods are delivered or services are provided. In the case of the magazine, and assuming that it publishes one issue per month, 1/12 of the revenue would be earned each month. The term "payable" is typically not used when the obligation is to be settled by the provision of goods or services. Accrued expenses According to the matching principle, expenses must be recorded in the period that the asset is consumed or service is used. Adjusting entries are required when expenses that have not yet been recorded have been incurred during the accounting period. To facilitate this requirement, accrued expenses are recorded by preparing adjusting entries. Two examples of expenses that may not have been recorded during the year are:

7 Page 7 of 27 The cost of cell phone from a provider such as FIDO: This is likely to occur as the invoice for the service provided in December is not usually received until January. Employees wages: This typically occurs when the employees normal payday (such as every second Friday) does not coincide with the company year end. As such, the firm owes the employees wages for the hours worked between the last payroll and year end. Accrued revenues The revenue recognition principle requires that revenue be recorded during the period that it is earned, regardless of when the actual cash is collected. Adjusting entries are required when revenue that has been earned during the accounting period has not yet been recorded. To satisfy this condition, accrued revenues are also recorded by preparing adjusting entries. A business that repairs a furnace on December 31 but does not send the invoice until January 5 would need to accrue revenues at December 31 to reflect the fact that this as yet unrecorded revenue had been earned. Accrued adjustments in later periods Expenses accrued at the end of an accounting period will result in cash payments in the next period. Similarly, the accrued revenues recorded at the end of one period will result in cash receipts in a subsequent period. You should be clear about how these items are journalized in the subsequent accounting period. Mid- Chapter Demonstration Problem on pages (included in the textbook activities following) is an example. Textbook activities Flashback questions 5-9 on page 152 Flashback question 14 on page 167 Mid-Chapter Demonstration Problem on pages Adjusted trial balance and preparation of financial statements Learning objective Prepare an adjusted trial balance, and use it to prepare financial statements. (Level 1) Required reading Chapter 4, pages Appendix 5A, pages (Level 3) LEVEL 1 After the adjusting entries have been recorded and posted to the general ledger, a new trial balance is prepared. This report is called an adjusted trial balance to reflect the fact that the account balances now recorded include the required end-of-period adjustments. Exhibit 4.22 on page 154 demonstrates how to prepare the adjusted trial balance using a partial work sheet.

8 Page 8 of 27 The Unadjusted trial balance numbers reflect the balances in the ledger accounts before the adjusting journal entries at the end of the accounting period. The Adjustments columns show the adjustments that must be made to various accounts to bring them to their proper balances. The adjusted trial balance is the result of the unadjusted trial balance and the adjustments. The account balances on the adjusted trial balance are the up-to-date ledger balances, which will be used in the preparation of the income statement, statement of owner s equity, and balance sheet. Accounts are normally arranged in the ledger, and therefore on the trial balance, in the order that they appear in the statements that is, assets, liabilities, owner s equity, revenues, and expenses. Each account on the adjusted trial balance is therefore either a balance sheet account, a statement of owner s equity account, or an income statement account. Exhibits 4.23 and 4.24 on pages demonstrate how the accounts from the income statement, the statement of owner s equity, and the balance sheet are created using the adjusted trial balance. The income statement is prepared first because the net income amount is needed to complete the statement of owner s equity. The closing capital balance from this latter statement is in turn carried forward to the balance sheet, which is prepared last. Textbook activities Flashback questions on page156 Judgement Call on page 157 Demonstration Problem and solution on pages Take particular note of the "Planning the Solution" section. Problem 5-11A on page 247 Solution 3.3 Adjusted trial balance and preparation of financial statements - Content Links

9 Page 9 of 27 Problem 5-11A solution

10 Page 10 of The work sheet Learning objective

11 Page 11 of 27 Prepare financial statements for a service business from the information in a work sheet. (Level 2) Required reading Chapter 5, pages LEVEL 2 A work sheet is a working paper used by an accountant to organize accounting information for preparing the financial statements and adjusting entries. Preparing work sheets is an optional procedure in the accounting cycle and summarizes steps 4, 5, and 6 shown in Exhibit 5.1 on page 200. Financial statements are used externally and must follow certain formats. Work sheets, however, are informal documents for the accountant s use only, and enable the accountant to see the entire accounting process from beginning to end. The benefits of using a work sheet and the required steps to complete them are explained on pages An extended example illustrating these five steps is provided in Exhibits on pages Work through this example now to get some hands-on practice. Textbook activity Flashback questions 1-3 on page Closing entries Learning objective Prepare closing entries for a service business. (Level 1) Required reading Chapter 5, pages LEVEL 1 Accounts are either permanent or temporary in nature. Balance sheet accounts are permanent accounts, while income statement accounts are temporary. Permanent accounts are continuous accounts their balances are carried forward from one accounting period to the next. Using cash as an example, the cash account balance fluctuates during the accounting period as deposits and payments are made. The ending cash balance from one period becomes the beginning cash balance for the next period; therefore, the account continues from one period to the next. Temporary accounts are periodic accounts, and at the end of each accounting period, their balances are closed (transferred) to owner s equity. The sales account, for example, is a temporary account. The sales account for each accounting period begins with a zero balance. Closing entries transfer the balances in the temporary accounts (revenue, expense, and withdrawals

12 Page 12 of 27 accounts) to a balance sheet equity account (owner s capital for a sole proprietorship). The closing process is described on pages and illustrated in Exhibits on pages Work through the example and check your understanding of the subject. Textbook activity Flashback questions 4-5 on page Post-closing trial balance Learning objective Prepare a post-closing trial balance. (Level 1) Required reading Chapter 5, pages LEVEL 1 A final step is needed to ensure that the journalizing and posting of closing entries have been done properly. After the closing entries are journalized and posted, the temporary accounts should have a zero balance. The permanent accounts are still open. The post-closing trial balance is prepared to ensure that total debits still equal total credits in the remaining permanent accounts. The income statement accounts and withdrawals account should have zero balances because they have been closed. Only balance sheet accounts will appear in the post-closing trial balance. Read pages to see how the post-closing trial balance is prepared. Textbook activity Flashback questions 6 on page The accounting cycle Learning objective Review the steps in the accounting cycle. (Level 1) Required reading Chapter 5, pages

13 Page 13 of 27 LEVEL 1 You have now completed the nine-steps of the accounting cycle as described on pages You can also refer to Exhibit 2-1. Preparing reversing entries at the beginning of the next fiscal year is not examinable. However, if you re interested, go to Appendix 5A on pages for an overview. Textbook activities Flashback question 7 on page 213 Mid-Chapter Demonstration Problem and solution on pages (Remember that the owner s withdrawals are closed directly to the capital account, not to income summary.) 3.8 Classification of balance sheet items Learning objective Prepare a classified balance sheet. (Level 1) Required reading Chapter 5, pages LEVEL 1 Balance sheets can be arranged in account form (see Exhibit 2.4 on page 36) or report form (called an unclassified balance sheet see Exhibit 4.24 on page 156). A classified balance sheet is one that shows assets and liabilities grouped in meaningful subclasses, as shown in Exhibit 5.18 on page 217. Here, assets are grouped into four categories: current assets long-term investments property, plant and equipment intangible assets Liabilities are grouped into two categories: current liabilities long-term liabilities Owner s equity represents the last subclass, and its format depends on whether the company is a sole proprietorship, a partnership, or a corporation. The text describes the classes on pages Most balance sheets are classified. They are prepared in this manner to provide more useful information to the user. For example, the relationship of a firm s current assets to its current liabilities gives creditors some insight into the firm s ability to meet its short-term obligations. This relationship is known as the current

14 Page 14 of 27 ratio. Textbook activities Flashback questions 8-10 on page 219 Demonstration Problem on pages Work out the problem before looking at the solution to confirm your knowledge of how to prepare financial statements from an adjusted trial balance. 3.9 Using the information Current ratio Learning objective Calculate the current ratio and explain its meaning. (Level 2) Required reading Appendix 5B, page 225 LEVEL 2 One advantage of classifying a balance sheet is that important relationships within the balance sheet can be easily obtained and analyzed. One such relationship is the current ratio as a measure of a company s short-term debt-paying ability. This type of information is particularly useful to suppliers and bankers that do business with a firm. The current ratio is determined as follows: Current ratio = A current ratio of 1.3 indicates that a company has $1.30 of current assets for each dollar of current debt. Textbook activity Current assets Current liabilities Flashback question 12 on page 225 Audio lectures Audio lectures are available for this module. System requirements and instructions on how to access the online lectures are included.

15 Page 15 of 27 Module 3 summary Adjusting the accounts, preparing the statements, and completing the accounting cycle Explain the need for financial statements and account adjustments at the end of regular accounting periods, and the purpose of the accrual basis of accounting. The life of a business is divided into accounting periods so that periodic financial reports can be prepared and used to evaluate the financial progress of the business. Before financial statements can be prepared, the accounts must be reviewed to ensure they properly reflect the substance of the economic events as required by GAAP. Adjustments at the end of each period are necessary to update some of the asset, liability, expense, and revenue accounts and to show the effects of previously unrecorded economic events of the business. Accrual accounting requires adjustments for prepaid, unearned, and accrued items; therefore, it reports revenues when earned and expenses when the expiration of benefit is incurred. Cash basis accounting does not make adjustments for prepaid expenses, accrued expenses, unearned revenues, and accrued revenues; revenues are recorded when cash is received and expenses are recorded when cash is paid. The cash basis of accounting is not generally accepted. Prepare adjusting entries for prepaid expenses, amortization, unearned revenues, accrued expenses, and accrued revenues. Step 5: Adjusting the accounts Adjusting entries are journalized in the general journal and then posted into the general ledger. Adjusting entries are used to: charge the expired portion of prepaid expenses to Expense charge the expired portion of tangible capital assets cost to Amortization expense accrue expenses and record the related liabilities recognize as revenues the earned portion of unearned revenue liabilities accrue revenues and record the related assets Prepare an adjusted trial balance, and use it to prepare financial statements. Steps 6 and 7: The adjusted trial balance and preparation of financial statements The sixth step in the accounting cycle is the preparation of an adjusted trial balance to prove the equality of debits and credits upon completion of the adjustment process. The seventh step in the accounting cycle is preparing the financial statements using the adjusted account balances as summarized on the adjusted trial balance. When accrued expenses are paid early in a new accounting period, the entry to record the payment includes a debit to the previously recorded liability and a debit to expense for the portion that expired during the new period. When payment of accrued revenues is received, the entry includes a credit to the previously recorded

16 Page 16 of 27 asset and a credit to revenue for the portion earned during the new period. Prepare financial statements for a service business from the information in a work sheet. A work sheet is a tool the accountant uses at the end of an accounting period to show the effects of the adjustments and organize the data for use in preparing financial statements and recording the adjusting and closing entries. The work sheet is an internal working paper that incorporates steps 4 (unadjusted trial balance) through 7 (preparation of financial statements) of the accounting cycle. Prepare closing entries for a service business. Step 8: Closing entries Closing the temporary accounts at the end of each accounting period serves to transfer the effects of these accounts to the proper owner s equity account that appears on the balance sheet. It also gives the revenue, expense, and withdrawals (or dividend for a corporation) accounts zero balances, preparing them for use in the following period. Closing involves the following steps: Revenues are closed to the Income summary account. Expenses are closed to the Income summary account. The balance in the Income summary account is closed to the Owner s capital account. The Owner s withdrawals account is closed to the Owner s capital account. Prepare a post-closing trial balance. Step 9: Post-closing trial balance The two main goals of the post-closing trial balance are to test the equality of debits and credits in the general ledger after the closing entries have been posted confirm that all temporary accounts have been closed Review the steps in the accounting cycle. The nine steps in the accounting cycle are: 1. Analyze economic events. 2. Journalize transactions in the general journal. 3. Post from the general journal to the general ledger. 4. Prepare the unadjusted trial balance. 5. Journalize and post adjusting entries. 6. Prepare the adjusted trial balance. 7. Prepare financial statements. 8. Journalize and post closing entries. 9. Prepare post-closing trial balance. Prepare a classified balance sheet. A classified balance sheet categorizes asset, liability, and equity accounts.

17 Page 17 of 27 Classified balance sheets usually report four classes of assets: current assets investments property, plant and equipment intangible capital assets Liabilities are classified as: current liabilities, or long-term liabilities The equity of a sole proprietorship is reported on one line, while a separate capital account is reported for each partner in a partnership. The equity section of Corporations is called Shareholders Equity. Calculate the current ratio and explain its meaning. A company s current ratio describes its ability to pay current liabilities out of current assets. Current ratio = Current assets / Current liabilities Module 3 Self-test Question 1 Multiple-choice questions a. The Office supplies account shows a beginning balance of $600 and an ending balance of $400. If office supplies expense for the year is $3,100, what amount of office supplies was purchased during the period? 1. $2, $2, $3, $3,500 b. HCF, a finance company, lends Able Business $2,400 at 5% for 3 months on December 1, What should HCF s adjusting entry on December 31, 2005 include? 1. A debit to Interest earned for $10 2. A credit to Interest receivable for $10 3. A credit to Interest earned for $10 4. A debit to Cash for $10 c. Josh s Computer Business owns computer equipment that cost $6,000 when it was purchased three years ago. Its current book value is $2,400. What is the amortization expense per year using straightline amortization? 1. $ $ 1, $ 1, $ 1,200 d. Which of the following describes the current ratio?

18 Page 18 of It is current assets divided by total liabilities. 2. It helps to assess a company s ability to pay its debts in the near future. 3. It reveals that the business has a very good cash flow position if it is less than It is current liabilities divided by current assets. e. The Jon Godfrey, Capital account has a debit balance of $1,200 before closing entries are made. If total revenues for the year are $55,200, total expenses $39,800, and withdrawals are $9,000, what is the ending balance in the Jon Godfrey, Capital account after all closing entries have been made? Solution Question 2 1. $ 5, $ 7, $ 14, $ 16,600 Problem 4-7A, page 179 Solution Question 3 Problem 4-17A, page 184 (Note: Only Part 2 is required.) Solution Question 4 A & R Problem 4-1, page 194 Solution Question 5 Exercise 5-5, page 232 Solution Question 6 The following information was extracted from Auto Doctor, a club that requires its annual subscription fee to be paid in advance.

19 Page 19 of 27 Required Calculate the following: a. Subscription income for 2005 b. Subscription fees for 2005 received in 2004 c. Subscription fees for 2005 received in 2005 d. Subscription fees received during 2005 Solution Question 7 Problem 5-9B, page 255 Solution Question 8 Hanson and Thorne found that its preliminary trial balance was not balancing. On perusal, they found the following errors: a. Money received from a customer for $800 account receivable was debited to cash and credited to accounts payable. b. An amount of $7,200 paid to a supplier was wrongly posted as $7,020 in the accounts payable account. c. Interest of $1,200 received from an investment was credited to the interest expense account. d. The balance in the accumulated amortization was wrongly carried to the trial balance as $3,000 instead of the correct balance of $8,000. e. A cheque for $5,700 received from a customer in payment of an accounts receivable was not deposited and no entry was made in the books. Required Indicate how the trial balance total will change when each one of the errors is corrected. Identify the dollar amount and state whether these will result in an Increase (+), Decrease ( ), or No Change (NC) in the debit and credit side totals. Use the following format for your answer: Solution

20 Page 20 of 27 Self-test - Content Links Solution 1 Multiple-choice a. b. a. Incorrect. A beginning balance of $600 plus office supplies purchased during the year less office supplies used (expensed) for the year of $3,100 equals the ending balance of $400 ($600 $3,100 + x = $400). Solving for x, office supplies purchased during the period was $2,900. b. Correct. A beginning balance of $600 plus office supplies purchased during the year less office supplies used (expensed) for the year of $3,100 equals the ending balance of $400 ($600 $3,100 + x = $400). Solving for x, office supplies purchased during the period was $2,900. c. Incorrect. $600 + $3,100 $400 = $3,300, which is incorrect because the $3,100 was used (expensed) and not purchased. d. Incorrect. The beginning balance of $600 must be subtracted from the supplies available since these were not purchased during this accounting period. 1. Incorrect. A debit to Interest earned for $10 would reduce it when an increase is the desired result. 2. Incorrect. A credit to Interest receivable for $10 would reduce it when an increase is the desired result. 3. Correct. The full entry on December 31, 2005, would be: This includes a credit to Interest earned of $ Incorrect. A debit to Cash for $10 means cash is collected on December 31, 2005; cash will not be received until the note matures. c. d. 1. Incorrect. $2,400 3 years = $800, but $2,400 is the remaining undepreciated capital cost of the asset. 2. Incorrect. Cost less Accumulated amortization = Book value; or Cost less Book value = Accumulated amortization. Therefore, $3,600 3 years = $1,200 amortization per year. 3. Incorrect. Cost less Accumulated amortization = Book value; or Cost less Book value = Accumulated amortization. Therefore, $3,600 3 years = $1,200 amortization per year. 4. Correct. Cost less Accumulated amortization = Book value; or Cost less Book value = Accumulated amortization. Therefore, $3,600 3 years = $1,200 amortization per year. 1. Incorrect. It should be current assets divided by total current liabilities. 2. Correct. The current ratio helps to assess a company s ability to pay its debts in the near future.

21 Page 21 of Incorrect. If the current ratio is less than 1, it calls into question the company s ability to pay its debts in the near future (that is, if the current ratio is 0.9, that would indicate that the company has $0.90 of current assets to cover each $1.00 of current debt). 4. Incorrect. Current liabilities divided by current assets is the current ratio formula inverted; the current ratio is current assets divided by current liabilities. e. 1. Correct. The normal balance for Capital is a credit; therefore, the beginning debit balance of $1,200 in Jon Godfrey, Capital represents a negative amount. You know that the beginning balance of Capital of $1,200 plus net income of $15,400 (calculated as revenues of $55,200 less expenses of $39,800) less withdrawals of $9,000 equals an ending Capital balance of $5, Incorrect. The $1,200 is a debit balance and should be subtracted and not added to arrive at the correct answer. 3. Incorrect. Withdrawals must be subtracted to arrive at the post-closing balance in capital. 4. Incorrect. Withdrawals must be subtracted to arrive at the post-closing balance in capital; the $1,200 beginning balance is a debit (negative) and must also be subtracted.

22 Page 22 of 27 Solution 2

23 Page 23 of 27 Solution 3 Entries that initially recognize expenses and revenues: Solution 4 1. $388, $22,520

24 Page 24 of $398,120 $22,520 = $375, ($388,400 + $22,520) $398,120 = $12,800 This question tests your understanding of how transactions impact a liability account, and your ability to calculate various expenses related to the liability account. To get started, think about what types of transactions would have occurred to the Salaries expense and Salaries payable accounts throughout the year and how these transactions would be recorded. You may find T-accounts to be a helpful tool. 1. Salary expense throughout the year would be recorded as a debit to Salaries expense and a credit to Salaries payable. Therefore, the salary expense for 2005 is equal to the total credits recorded to the Salaries payable account ($388,400). 2. Salaries related to work done in 2004 but not paid for until 2005 would be represented by the opening balance in the Salaries payable account ($22,520), because on the last day of 2004, an accrual would have been booked to expense all salaries for work done during the year. Because this amount would not have been paid until 2005, it would have been credited to the Salaries payable account until it was paid. 3. The amount paid in 2005 for work done in 2005 would be represented by the total amount expensed during the year, less the unpaid balance in the Salaries payable account at the end of the year (remember that the amount expensed equals the credit in the payables account see point 1): Total salaries expense = $388,400. Balance in Salaries payable account at end of year = ($22,520 + $388,400 $398,120) = $12,800. Therefore, the amount paid in 2005 for work done in 2005 = $388,400 $12,800 = $375,600. You could also determine the amount paid in 2005 for work done in 2005 by calculating the total cash paid during the year (this would equal total debits to the payable account), less the amount that was paid for work done in 2004 ($22,520, from part 2). Looking at it this way, the amount paid in 2005 for work done in 2005 = $398,120 $22,520 = $375, The amount that will be paid to employees in 2006 for work done in 2005 will be represented by the balance in the Salaries payable account at the end of In part 3, the ending balance was calculated to be $12,800. Solution 5 Part 1 Net income = $36,800 Part 2

25 Page 25 of 27 Part 3 $63,000 + $36,800 $17,000 = $82,800 Solution 6 Advance subscriptions a. $70,000 b. $40,000 c. $30,000 d. $80,000 $ 40,000 (b) Subscriptions applied 70,000 (a) (30,000) (c) Balance, December 31, ,000 (given) Collected $ 80,000 (d) Solution 7

26 Page 26 of 27

27 Page 27 of 27 Solution 8

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