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

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2 Assignment reminder: Assignment #1 (see Module 5) is due at the end of week 5 (see Course Schedule). You may wish to take a look at it now in order to familiarize yourself with the requirements and to prepare for any necessary work in advance. FA1 - Module 3 Page 2 of 71

3 Course Schedule Course Modules Review and Practice Exam Preparation Resources Module 3 Test your knowledge a. If an accountant forgot to record depreciation 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, 20X1. The truck is estimated to have a useful life of six years and a salvage value of \$6,000. How much depreciation expense will be recorded for the truck during the year ended December 31, 20X1, 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 postclosing trial balance? 1. Office equipment 2. Accumulated depreciation, office equipment 3. Depreciation expense, office equipment 4. Ted Nash, capital FA1 - Module 3 Page 3 of 71

4 Solutions FA1 - Module 3 Page 4 of 71

5 Course Schedule Course Modules Review and Practice Exam Preparation Resources Module 3 Test your knowledge solutions a. 1. Incorrect. The entry to record depreciation 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 depreciation is not recorded, assets will be overstated on the balance sheet. 2. Incorrect. The entry to record depreciation 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 depreciation is not recorded, assets will be overstated on the balance sheet. 3. Incorrect. The entry to record depreciation 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 depreciation is not recorded, assets will be overstated on the balance sheet. 4. Correct. The entry to record depreciation 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 depreciation 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 depreciation expense will be recorded for the truck during the year ended December 31, 20X1, because the truck was purchased on July 1, 20X1, resulting in a partial period of depreciation (\$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 depreciation for a full year; depreciation 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. FA1 - Module 3 Page 5 of 71

6 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. 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 depreciation, office equipment, is a contra-asset account. The post-closing trial balance includes contra-assets because they are permanent accounts. 3. Correct. Depreciation expense, office equipment, should not be included on the post-closing trial balance because expenses are temporary accounts, which are closed into Capital. If Depreciation expense, office equipment, appears on the postclosing 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. FA1 - Module 3 Page 6 of 71

8 Quick Study The timeliness principle has been violated since businesses must report at regular intervals which is normally in 1 year intervals or less. 2. The matching principle has been violated because the supplies purchased on September 30 will probably not have been used entirely on that date. Warren has not accurately matched the expense of using the supplies to the accounting period in which they were/will be used. 3. The revenue recognition principle has been violated. Although Mindy has collected the cash it is not a revenue until it has been earned. The \$3,000 will not begin to be earned until June 1 therefore it should not be recorded as a revenue on May 3. Therefore, the \$3,000 should be recorded as a liability (i.e., unearned revenue). 4. The matching principle has been violated. TelsCo has rented the equipment therefore an expense has been incurred although cash will not be paid until sometime in the future. Quick Study 4-2 Cash basis: Revenues (cash receipts)... \$33,000 Expenses (cash payments) (\$22,500 \$2,250 + \$3,750)... 24,000 Net income... \$ 9,000 Accrual basis: Revenues (earned)... \$39,000 Expenses (incurred)... 22,500 Net income... \$16,500 FA1 - Module 3 Page 8 of 71

9 Course Schedule Course Modules Review and Practice Exam Preparation Resources 3.2 Adjusting the accounts Learning objective Prepare adjusting entries for prepaid expenses, depreciation, unearned revenues, accrued expenses, and accrued revenues. (Level 1) Required reading LEVEL 1 Chapter 4, pages Appendix 4B, pages Five types of adjustments are presented in the text prepaid expenses, depreciation, 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. 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 recorded. 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. You can see this illustrated on pages in Appendix 4B. 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. Textbook activities Depreciation Checkpoint Question 5 on page 136 (Solution on page 151) Quick Study 4-3 on page 161 (Solution) Depreciation is an accounting term used in conjunction with the process of assigning the cost of plant and equipment assets (for example, equipment and buildings) to the periods that they contribute to the firm s revenues. It is important to note that depreciation is a method of cost allocation, not asset valuation. A plant and equipment asset whose market value is increasing is still depreciated because while the asset generates FA1 - Module 3 Page 9 of 71

10 revenues, it gradually wears out. (An exception is land, which is never depreciated 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 activities Judgement Call on page 138 (solution on page 151) Checkpoint Questions 6 and 7 on page 138 (Solutions on page 151) Quick Study 4-4 on page 161 (Solution) Unearned revenues Unearned revenue (also called 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 obligation to provide the magazines in the future. 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. Textbook activities Accrued expenses Checkpoint Questions 8 and 9 on page 139 (Solutions on page 151) Quick Study 4-5 on page 161 (Solution) According to the matching principle, expenses must be recorded in the same period as the revenues that were earned as a result of the expenses. 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 The cost of cellular phone service 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. Note: The solution to Checkpoint Question 10 should be changed as follows: The omission of the \$6,900 interest utility expense accrual will cause liabilities to be understated by \$6,900 and equity to be overstated by \$6,900. Textbook activity Checkpoint Questions 10 and 11 on page 142 (Solutions on page 151) FA1 - Module 3 Page 10 of 71

11 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. Textbook activities Checkpoint Question 13 on page 144 (Solution on page 151) Quick Study 4-8 on page 162 (Solution) Accrued adjustments in later periods Expenses accrued at the end of an accounting period will affect the recording of the related 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. The Mid-Chapter Demonstration Problem on pages (included in the textbook activities following) is an example. Textbook activities Checkpoint Question 12 on page 142 and question 14 on page 145 (Solutions on pages 151) Quick Study 4-6, 4-7, 4-9, and 4-10 on pages (Solutions) Note: that for part (a), prepaid expenses, consider the effect if the expense portion of the prepaid expense is not transferred to the expense account. Mid-Chapter Demonstration Problem on pages FA1 - Module 3 Page 11 of 71

12 Quick Study a) Apr. 1 Prepaid Insurance... 7,680 Cash... 7,680 To record purchase of two-year insurance policy b) Dec. 31 Insurance Expense... 2,880 Prepaid Insurance... 2,880 To record the use of nine months of prepaid insurance; 7,680/24 = 320/month 9 months = 2, c) Dec. 31 Insurance Expense... 3,840 Prepaid Insurance... 3,840 To record the use of 12 months of prepaid insurance; 320/month 12 months = 3,840 OR 7,680/2 = 3,840. d) 3 months or \$960 calculated as 3 months \$320 = \$960. FA1 - Module 3 Page 12 of 71

13 Quick Study Mar. 1 Vehicle... 32,000 Cash... 32,000 To record purchase of vehicle. Dec. 31 Depreciation Expense, Vehicle... 5,000 Accumulated Depreciation, Vehicle... 5,000 To record 10 months of depreciation on the vehicle; 32,000 8,000 = 24,000; 24,000/4 yrs = 6,000/yr; 6,000/12 = 500/month; 500/month 10 months = 5,000 OR 24,000 10/48 = 5, Dec. 31 Depreciation Expense, Vehicle... 6,000 Accumulated Depreciation, Vehicle... 6,000 To record annual depreciation on the vehicle; (32,000 8,000)/4 years. FA1 - Module 3 Page 13 of 71

14 Quick Study Nov. 1 Cash... 12,000 Unearned Revenue... 12,000 To record cash received for services to be performed in the future. Dec. 31 Unearned Revenue... 9,000 Revenue... 9,000 To record amount of advance payment earned. FA1 - Module 3 Page 14 of 71

15 Quick Study 4-8 Debits Credits a. 4 3 b c d. 7 8 e. 4 2 FA1 - Module 3 Page 15 of 71

16 Quick Study Dec. 31 Telephone Expense... 1,840 Accounts Payable or Telephone Payable... 1,840 To accrue the December telephone bill Jan. 14 Accounts Payable or Telephone Payable... 1,840 Cash... 1,840 To record payment of December 31 accrual. Quick Study Mar. 31 Accounts Receivable... 17,000 Revenues... 17,000 To record accrued revenues. Apr. 16 Cash... 12,000 Accounts Receivable... 12,000 To record collection of receivable. Quick Study 4-9 a. Debit Depreciation Expense Income Statement Credit Accumulated Depreciation Balance Sheet b. Debit Wages Expense Income Statement Credit Wages Payable Balance Sheet c. Debit Unearned Revenue Balance Sheet Credit Revenue Account Income Statement d. Debit Insurance Expense Income Statement Credit Prepaid Insurance Balance Sheet e. Debit Accounts Receivable Balance Sheet Credit Revenue Account Income Statement FA1 - Module 3 Page 16 of 71

17 Quick Study 4-10 If adjustment is not recorded: Net income will be overstated, Assets will be overstated, Liabilities will be overstated, Equity will be overstated, understated, or understated, or understated, or understated, or no Type of no effect no effect no effect effect Adjustment a. Prepaid Expenses Overstated Overstated No effect Overstated b. Depreciation Overstated Overstated No effect Overstated c. Unearned Understated No effect Overstated Understated Revenues d. Accrued Overstated No effect Understated Overstated Expenses e. Accrued Revenues Understated Understated No effect Understated FA1 - Module 3 Page 17 of 71

19 Quick Study Oct. 31 Insurance Expense Prepaid Insurance To record expired prepaid insurance. 31 Interest Expense Interest Payable To record accrual of interest. FA1 - Module 3 Page 19 of 71

20 Course Schedule Course Modules Review and Practice Exam Preparation Resources 3.4 The work sheet Learning objective Prepare financial statements for a service business from the information in a work sheet. (Level 2) Required reading LEVEL 2 Chapter 5, pages 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 190. 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. It s important to note that a worksheet does not eliminate the need to journalize and post adjustments to the ledger. It is merely a tool to assist with the process. When all entries are posted to the ledger, balances should be checked against the worksheet account balances to ensure the adjustments are correct. The benefits of using a work sheet and the required steps to complete them are explained on pages An example illustrating these five steps is provided in Exhibit 5.3 on page 193. Work through this example to help you understand the steps in preparing a work sheet. Textbook activity Checkpoint Questions 1 to 3 on page 194 (Solutions on page 210) Quick Study 5-1 to 5-4 on pages (Solution) FA1 - Module 3 Page 20 of 71

21 Quick Study BS 4. BS 2. BS 5. BS 3. IS 6. IS Quick Study 5-2 Balance Sheet Unadjusted Adjusted & Statement of Trial Balance Adjustments Trial Balance Income Statement Changes in Equity Account Dr Cr Dr Cr Dr Cr Dr Cr Dr Cr Cash Accounts receivable Supplies Ed Wolt, capital Ed Wolt, withdrawals Fees earned Supplies expense Totals Net income Copyright 2010 by McGraw-Hill Ryerson Limited. All rights reserved. Solutions Manual for Chapter 5 1 FA1 - Module 3 Page 21 of 71

22 Quick Study 5-3 Alice Pursley, capital for the December 31, 2011 balance sheet: Beginning capital... \$50,000 Add: Net income (\$184,000 \$125,000)... 59,000 Less: Withdrawals... 32,000 Ending capital... \$77,000 Quick Study 5-4 Sam Hascal, Capital for the December 31, 2011, balance sheet: Beginning capital... \$165,000 Less: Net loss (\$74,000 \$115,000)... 41,000 Less: Withdrawals... 32,000 Ending capital... \$ 92,000 Copyright 2010 by McGraw-Hill Ryerson Limited. All rights reserved. Solutions Manual for Chapter 5 2 FA1 - Module 3 Page 22 of 71

23 Course Schedule Course Modules Review and Practice Exam Preparation Resources 3.5 Closing entries Learning objective Prepare closing entries for a service business. (Level 1) Required reading LEVEL 1 Chapter 5, pages Accounts are either permanent or temporary in nature. Balance sheet accounts are permanent accounts, while income statement accounts and the withdrawals account 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 revenue account, for example, is a temporary account. The revenue account for each accounting period begins with a zero balance. Closing entries transfer the balances in the temporary accounts (revenue, expense, and withdrawals accounts) to a balance sheet equity account (owner s capital for a sole proprietorship). The closing process is described and illustrated on pages Work through the example in Exhibits 5.7 to 5.9 and check your understanding of the subject. Textbook activity Checkpoint Questions 4 and 5 on page 201 (Solutions on page 210) Quick Study 5-5 to 5-7 on pages (Solutions) FA1 - Module 3 Page 23 of 71

24 Quick Study 5-5 Income Summary balance after closing revenues and expenses: Revenues: \$35,000 + \$3, = \$38,500 Expenses: \$19,000 + \$4,000 + \$2, = 25,300 Credit balance... = \$13,200 Peter Jontil, Capital balance after all closing entries: Beginning balance... \$14,000 Peter Jontil, Capital Add: Net income... 13,200 14,000 (Beg. Bal.) Total... \$27,200 OR (Withdrawals) 6,000 13,200 (Net income) Less: Withdrawals... 6,000 21,200 (End. Bal.) Ending balance... \$21,200 Copyright 2007 by McGraw-Hill Ryerson Limited. All rights reserved. Solutions Manual for Chapter 5 1 FA1 - Module 3 Page 24 of 71

25 Copyright 2010 by McGraw-Hill Ryerson Limited. All rights reserved. Solutions Manual for Chapter Quick Study (1) Apr 30 Revenue Income Summary To close the revenue account. (2) 30 Income Summary Expenses To close the expenses account. (3) 30 Income Summary Capital To close the income summary to capital. (4) 30 Capital Withdrawals To close withdrawals to capital. Assets Liabilities Capital Apr Apr Apr. 30 (4) (3) 220 Balance Withdrawals Revenue Expenses Apr (4) (1) Apr. 30 Apr (2) Balance Balance Balance -0- Income Summary (2) (1) (3) Balance -0- Balance FA1 - Module 3 Page 25 of 71

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