CHAPTER 3 Solutions MEASURING BUSINESS INCOME

CHAPTER 3 Solutions MEASURING BUSINESS INCOME Chapter 3, SE 1. 1. 2. 3. 4. c b d a Chapter 3, SE 2. Dec. 31 Insurance Expense 800 Prepaid Insurance To record insurance expired during the year $460 + $1,040 $700 = $800 800 Chapter 3, SE 3. Dec. 31 Supplies Expense 920 Supplies To record supplies used during the year $380 + $980 $440 = $920 920 Chapter 3, SE 4. Mar. 31 Depreciation Expense Office Equipment 100 Accumulated Depreciation Office Equipment To record depreciation for the month 100 Sheet Presentation: Office equipment Less accumulated depreciation $1,900 300 $1,600 Chapter 3, SE 5. 30 Wages Expense 230 Wages Payable To record wages accrued at the end of ( $1,380 6 ) 1 = $230 230 101

Chapter 3, SE 6. Aug. 31 Unearned Service Revenue 760 Service Revenue To record service revenue earned during August on which advance deposits had been received 760 Chapter 3, SE 7. Revenue Service revenue Expenses Wages expense Rent expense Income taxes expense Utilities expense Telephone expense Total expenses Net income Retained earnings, November 30, Net income Subtotal Less dividends Retained earnings, December 31, Shimura Company Income Statement For the Month Ended December 31, Shimura Company Statement of Retained Earnings For the Month Ended December 31, $450 200 175 100 25 $1,300 950 $ 350 $4,300 350 $4,650 175 $4,475 102

Chapter 3, SE 8. Closing entries prepared Dec. 31 Service Revenue 1,300 Income Summary To close the revenue account Income Summary 950 Wages Expense Rent Expense Income Taxes Expense Utilities Expense Telephone Expense To close the expense accounts Income Summary 350 Retained Earnings To close the Income Summary account Retained Earnings 175 Dividends To close the Dividends account 1,300 450 200 175 100 25 350 175 103

Chapter 3, SE 9. Cloud Company Income Statement For the Month Ended October 31, Revenue Service revenue Expenses Wages expense Rent expense Income taxes expense Utilities expense Telephone expense Total expenses Net income $675 300 263 150 38 $1,950 1,426 $ 524 Retained earnings, September 30, Net income Subtotal Less dividends Retained earnings, October 31, Cloud Company Statement of Retained Earnings For the Month Ended October 31, $6,450 524 $6,974 263 $6,711 104

Chapter 3, SE 10. Closing entries prepared Dec. 31 Service Revenue 1,950 Income Summary To close the revenue account Income Summary 1,426 Wages Expense Rent Expense Income Taxes Expense Utilities Expense Telephone Expense To close the expense accounts Income Summary 524 Retained Earnings To close the Income Summary account Retained Earnings 263 Dividends To close the Dividends account 1,950 675 300 263 150 38 524 263 105

Chapter 3, SE 11. Unearned Revenue at December 31 Service Revenue earned during December Potential receipts from services provided during December Less Unearned Revenue at November 30 Cash received during December for services to be provided $ 450 2,550 $3,000 650 $2,350 Chapter 3, SE 12. Financial ratio calculated: Cash Flow Yield = Cash Flow from Operations Net Income $8,750 = = 1.3 $7,000 = 1.3 times 106

Chapter 3, E 1. 1. 2. 3. 4. When a company has net income, its stockholders' equity increases, but there is also an increase in assets and/or decrease in liabilities. To measure a company's performance (net income) accurately, each expense (in this case, guaranty or warranty expense) must be matched with the related revenue in the year in which the product or service was sold. Otherwise, net income will be overstated, and the related liability will be understated. Accrual accounting is more closely related to profitability because the purpose of accrual accounting is to measure net income. Cash accounting is more closely related to the goal of liquidity. No, the carrying value will equal the market value of the asset only by coincidence because the goal of recording depreciation is to allocate the cost of the asset over its life, not to determine its market value. Chapter 3, E 2. 1. 2. 3. Retained Earnings is not listed because it begins with a zero balance in the first month of operation. It does not yet reflect the amounts of revenues, exthe Supplies T account. The amount expended in cash to purchase supplies penses, and dividends for the year, which are listed in the adjusted trial balance. You would expect to find the amount expended in cash on the debit side of represents an asset increase and is recorded by a debit to Supplies. The amount expensed during the period represents an asset decrease and is recorded by a credit to Supplies. Cash flow yield is a good measure of liquidity and is closely related to the goal of liquidity. It tells how much cash is generated by the company's operations in relation to its net income. Chapter 3, E 3. (Note to the instructor: Because more than one concept may apply to a particular action, which concept is most applicable is a matter of judgment. This exercise is intended to generate discussion.) 1. b 4. 2. d 5. 3. e 6. a f c 107

Chapter 3, E 4. 1. 2. 3. 4. Services have not been rendered. Persuasive evidence of an arrangement does not exist. Collectibility is not reasonably assured. The seller's price to the buyer is not fixed or determinable. Chapter 3, E 5. Dec. 31 Magazine Subscriptions Received in Advance 87,500 Magazine Subscriptions Revenue To recognize revenue for subscriptions expired during 87,500 Chapter 3, E 6. 1. Insurance Expense 17,150 Prepaid Insurance To record expired insurance $33,690 $16,540 = $17,150 2. Insurance Expense 4,300 Prepaid Insurance To record expired insurance 17,150 4,300 108

Chapter 3, E 7. 1. Amounts indicated by the question marks are in italics a b c d Supplies on hand at July 1 $264 $ 217 $196 $ 822 Supplies purchased during the month 52 1,191 174 1,928 Total supplies available $316 $1,408 $370 $2,750 Supplies consumed during the month 194 972 314 1,632 Supplies on hand at July 31 $122 $ 436 $ 56 $1,118 2. Adjusting entry for column a July 31 Supplies Expense 194 Supplies To record adjustment for supplies used 194 Chapter 3, E 8. 1. May 31 Salaries Expense 28,000 Salaries Payable To accrue salaries owed but not paid at month end $70,000 5 = $14,000 per day 2 work days (Monday and Tuesday) incurred = $28,000 2. 3 Salaries Expense 42,000 Salaries Payable 28,000 Cash To pay weekly salaries 28,000 70,000 109

Chapter 3, E 9. 1. Royalty expense and royalty income calculated January to (payment on November 1) $20,000 July to December ( $430,000 15 percent) 64,500 royalty expense and royalty income $84,500 Note: The $12,000 paid on May 1 relates to 2010. 2. Adjusting entries recorded In Bit Comp, Inc.'s records: Dec. Dec. 31 Royalty Expense 64,500 Royalty Payable To record royalties owed for the last half of, to be paid on May 1, In Regina Company's records: 31 Royalty Receivable 64,500 Royalty Income To record royalties earned for the last half of, to be received on May 1, 64,500 64,500 110

Chapter 3, E 10. Spark Cleaning Company, Inc. Income Statement For the Month Ended August 31, Revenue Janitorial revenue Expenses Wages expense Supplies expense Rent expense Income taxes expense Depreciation expense truck Gas, oil, and other truck expenses Insurance expense Depreciation expense cleaning equipment Total expenses Net income Spark Cleaning Company, Inc. Statement of Retained Earnings For the Month Ended August 31, Retained earnings, July 31, Net income Subtotal Less dividends Retained earnings, August 31, $5,680 2,920 1,200 800 720 580 380 320 $14,620 12,600 $ 2,020 $11,034 2,020 $13,054 2,000 $11,054 111

Chapter 3, E 10. (Continued) Cash Accounts receivable Prepaid insurance Prepaid rent Cleaning supplies Cleaning equipment Less accumulated depreciation Truck Less accumulated depreciation Total assets Accounts payable Wages payable Unearned janitorial revenue Income taxes payable Total liabilities Common stock Retained earnings Total stockholders' equity Total liabilities and stockholders' equity Spark Cleaning Company, Inc. Sheet August 31, Assets Liabilities Stockholders' Equity $ 4,590 2,592 380 200 152 $ 3,200 320 2,880 $ 7,200 720 6,480 $17,274 $ 420 80 920 800 $ 4,000 11,054 $ 2,220 15,054 $17,274 112

Chapter 3, E 11. Closing entries recorded Aug. 31 Janitorial Revenue 14,620 Income Summary To close the revenue account Income Summary 12,600 Wages Expense Supplies Expense Rent Expense Income Taxes Expense Depreciation Expense Truck Gas, Oil, and Other Truck Expenses Insurance Expense Depreciation Expense Cleaning Equipment To close the expense accounts 31 Income Summary 2,020 Retained Earnings To close the Income Summary account 31 Retained Earnings 2,000 Dividends To close the Dividends account 14,620 5,680 2,920 1,200 800 720 580 380 320 2,020 2,000 113

Chapter 3, E 12. 1. Office Supplies Expense 428 Office Supplies To record supplies consumed during the year Beginning balance $168 830 + Purchases = Total available Ending balance Supplies consumed $998 570 $428 2. Depreciation Expense Office Equipment 1,065 Accumulated Depreciation Office Equipment To record depreciation allocated to the year 3. Property Taxes Expense 900 Property Taxes Payable To record property taxes applicable to the sixmonth period 4. Interest Receivable 425 Interest Income To record interest accrued during the period 5. Unearned Revenue 375 Service Revenue To record revenue earned for services for which payment had been received in advance 6. Accounts Receivable 400 Service Revenue To record service revenue earned but not billed 428 1,065 900 425 375 400 114

Chapter 3, E 13. 1. Entries recorded Oct. Dec. 1 Cash 42,000 Unearned Legal Fees To record legal fees received in advance 31 Unearned Legal Fees 10,500 Legal Fees Earned To recognize three months' fees earned ( $42,000 12 months ) 3 months = $10,500 42,000 10,500 2. Revenue on the income statement includes the $10,500 in legal fees that have been earned. Unearned Legal Fees is a liability of $31,500 on the balance sheet. Chapter 3, E 14. Closing entries recorded Dec. 31 Consulting Fees Earned 31,700 Income Summary To close the revenue account 31 Income Summary 23,275 Office Salaries Expense Income Taxes Expense Rent Expense Advertising Expense Telephone Expense To close the expense accounts 31 Income Summary 8,425 Retained Earnings To close the Income Summary account 31 Retained Earnings 7,000 Dividends To close the Dividends account 31,700 13,500 3,000 2,650 2,525 1,600 8,425 7,000 115

Chapter 3, E 15. Statement of retained earnings prepared Retained earnings, December 31, 2010 Net income Subtotal Less dividends Retained earnings, December 31, Cindy's Beauty Salon, Inc. Statement of Retained Earnings For the Year Ended December 31, $52,000 44,000 $96,000 19,000 $77,000 Chapter 3, E 16. Prepaid Insurance at end of Insurance Expense during Potential payments for insurance during Less Prepaid Insurance at end of 2010 Cash payments for insurance during Wages Payable at end of 2010 Wages Expense during Potential payments for wages during Less Wages Payable at end of Cash payments for wages during Unearned Revenue at end of Fees Earned during Potential receipts from fees during Less Unearned Revenue at end of 2010 Cash receipts from fees during $ 1,200 1,900 $ 3,100 1,450 $ 1,650 $ 1,100 9,750 $10,850 600 $10,250 $ 2,100 4,450 $ 6,550 950 $ 5,600 116

Chapter 3, E 17. 1. Cash paid for rent during the year: $152,700 Ending balance Rent Expense Potential cash paid for rent Less beginning balance Cash paid during the year 2. Cash paid for interest during the year: $26,400 Beginning balance Interest Expense Potential cash paid for interest Less ending balance Cash paid during the year 3. Cash paid for salaries during the year: $229,000 Beginning balance Salaries Expense Potential cash paid for salaries Less ending balance Cash paid during the year $ 2,700 150,000 $ 152,700 $ 152,700 $ 3,000 23,400 $26,400 $26,400 $ 15,000 242,000 $257,000 28,000 $229,000 Chapter 3, E 18. Financial ratios calculated Cash Flow Yield = Cash Flows from Operating Activities Net Income $6,000 = = 1.2 or 1.2 $5,000 times 2010 = $5,500 $4,300 = 1.3 or 1.3 times 117

Chapter 3, P 1. Amount of Amount of Adjustment after Income Adjustment after Sheet Account (+ or ) Adjustment Statement Account (+ or ) Adjustment a. Prepaid Insurance $ 5,440 $ 1,360 Insurance Expense + $ 5,440 $ 5,440 b. Cleaning Supplies 12,448 2,300 Cleaning Supplies Expense + 12,448 12,448 c. Accumulated Depreciation Building + 25,600 116,800 Depreciation Expense Building + 25,600 25,600 d. Interest Payable + 2,000 2,000 Interest Expense + 2,000 24,000 e. Unearned Cleaning Revenue 850 2,550 Cleaning Revenue + 850 320,118 f. Wages Payable + 4,080 4,080 Wages Expense + 4,080 206,740 g. Income Taxes Payable + 4,600 4,600 Income Taxes Expense + 4,600 4,600 118

Chapter 3, P 2. 1. Adjusting entries recorded a. 30 Interest Expense 26,000 Interest Payable To record accrued interest on mortgage b. 30 Salaries Expense 22,440 Salaries Payable To record accrued salaries ( $37,400 5 days ) 3 days = $22,440 c. No entry d. 30 Supplies Expense 8,824 Supplies To record supplies used $3,230 + $8,230 $2,636 = $8,824 e. 30 Insurance Expense 6,514 Prepaid Insurance To record expired insurance $3,240 2,900 [( $5,800 12 months ) 6 months ] 374 [( $6,732 36 months ) 2 months ] $6,514 f. 30 Depreciation Expense Buildings Depreciation Expense Equipment 14,600 41,300 Accumulated Depreciation Buildings Accumulated Depreciation Equipment To record annual depreciation g. 30 Services Collected in Advance 3,600 Service Revenue To record service revenue earned on services collected in advance ( $43,200 12 months) 1 month = $3,600 h. 30 Accounts Receivable 9,000 Service Revenue To record service revenue earned on a contract to be billed in August i. 30 Income Taxes Expense 12,600 Income Taxes Payable To accrue estimated income taxes for the year 26,000 22,440 8,824 6,514 14,600 41,300 3,600 9,000 12,600 119

Chapter 3, P 2. (Continued) 2. User Insight: Revenue recognition discussed In transaction c, no revenue is recognized because even though a contract has been signed, no services have yet been provided or earned. In transaction h, the services have been provided and earned. Thus, in this case, it is appropriate to recognize revenue for the portion of the contract that has been completed. 120

Chapter 3, P 3. 1. T accounts set up and balances entered 2. Adjusting entries posted to the accounts Cash Accounts Receivable Office Supplies Bal. 9,250 Bal. 4,125 Bal. 1,331 (a) 1,181 (g) 1,550 Bal. 150 Bal. 5,675 Accumulated Depreciation Prepaid Rent Office Equipment Office Equipment Bal. 660 (b) 305 Bal. 4,620 Bal. 355 Accounts Payable Interest Payable Common Stock Service Revenue Utilities Expense (c) 263 Bal. 1,033 Bal. 2,970 Bal. 5,500 (f) 902 Bal. 1,485 Bal. 583 (d) 285 (e) 165 (h) 2,100 Bal. 6,000 Bal. 7,001 Bal. 11,000 Bal. 36,300 Bal. 24,700 Bal. 2,200 (f) 902 (e) 165 (b) 305 (g) 1,550 Bal. 24,865 Bal. 2,505 Bal. 38,752 Bal. 2,140 (a) 1,181 (c) 263 Interest Expense (d) 285 (h) 2,100 Notes Payable Salaries Payable Retained Earnings Salaries Expense Office Supplies Expense Income Taxes Expense Bal. Income Taxes Payable Dividends Rent Expense 770 Unearned Service Revenue Depreciation Expense Office Equipment 121

Chapter 3, P 3. (Continued) 3. Adjusted trial balance prepared Financial Service, Inc. Adjusted Trial December 31, Cash Accounts Receivable Office Supplies Prepaid Rent Office Equipment Accumulated Depreciation Office Equipment Accounts Payable Notes Payable Unearned Service Revenue Interest Payable Salaries Payable Income Taxes Payable Common Stock Retained Earnings Dividends Service Revenue Salaries Expense Rent Expense Utilities Expense Office Supplies Expense Depreciation Expense Office Equipment Interest Expense Income Taxes Expense $ 9,250 5,675 150 355 4,620 $ 1,033 2,970 5,500 583 285 165 2,100 6,000 7,001 11,000 38,752 24,865 2,505 2,140 1,181 263 285 2,100 $64,389 $64,389 122

Chapter 3, P 3. (Continued) 4. User Insight: The following financial statements are affected by the adjustments: a. b. c. d. e. f. g. h. sheet, income statement, statement of retained earnings sheet, income statement, statement of retained earnings sheet, income statement, statement of retained earnings sheet, income statement, statement of retained earnings sheet, income statement, statement of retained earnings sheet, income statement, statement of retained earnings sheet, income statement, statement of retained earnings sheet, income statement, statement of retained earnings The statement of cash flows is not affected by the adjustments. 123

Chapter 3, P 4. 1. T accounts set up and balances entered 2. Adjusting entries posted to the accounts Bal. Cash Accounts Receivable Prepaid Insurance 7,400 Bal. 2,198 Bal. 480 (b) 280 Bal. 200 Office Supplies Bal. 1,560 (a) 1,110 Bal. 14,200 Bal. 1,540 Bal. 450 (c) 1,590 Bal. 3,130 Accounts Payable Common Stock Tax Fees Revenue Rent Expense Bal. 1,270 (e) 438 Bal. 438 (f) 4,860 (d) 42 Bal. Bal. 1,312 Bal. 7,000 Bal. 6,878 Bal. 12,000 Bal. 43,852 Bal. 16,600 Bal. 1,300 (e) 438 Bal. 44,290 Bal. 4,800 Bal. 440 (b) 280 (d) 42 Bal. 482 Office Supplies Expense Office Equipment Unearned Tax Fees Revenue Retained Earnings Office Salaries Expense Telephone Expense Depreciation Expense Office Equipment (a) 1,110 (c) 1,590 (f) 4,860 Accumulated Depreciation Office Equipment Income Taxes Payable Dividends Advertising Expense Insurance Expense Income Taxes Expense 124

Chapter 3, P 4. (Continued) 3. Adjusted trial balance, income statement, statement of retained earnings, and balance sheet prepared Kazai Tax Service, Inc. Adjusted Trial December 31, Cash Accounts Receivable Prepaid Insurance Office Supplies Office Equipment Accumulated Depreciation Office Equipment Accounts Payable Income Taxes Payable Common Stock Retained Earnings Dividends Tax Fees Revenue Office Salaries Expense Advertising Expense Rent Expense Telephone Expense Insurance Expense Office Supplies Expense Depreciation Expense Office Equipment Income Taxes Expense $ 7,400 2,198 200 450 14,200 $ 3,130 1,312 4,860 7,000 6,878 12,000 44,290 16,600 1,300 4,800 482 280 1,110 1,590 4,860 $67,470 $67,470 Note: Unearned Tax Fees Revenue does not appear on the adjusted trial balance because it now has a zero balance. 125

Chapter 3, P 4. (Continued) Revenue Tax fees revenue Expenses Office salaries expense Income taxes expense Rent expense Depreciation expense office equipment Advertising expense Office supplies expense Telephone expense Insurance expense Total expenses Net income Kazai Tax Service, Inc. Income Statement For the Year Ended December 31, Kazai Tax Service, Inc. Statement of Retained Earnings For the Year Ended December 31, Retained earnings, December 31, 2010 Net income Subtotal Less dividends Retained earnings, December 31, $16,600 4,860 4,800 1,590 1,300 1,110 482 280 $44,290 31,022 $13,268 $ 6,878 13,268 $20,146 12,000 $ 8,146 126

Chapter 3, P 4. (Continued) Kazai Tax Service, Inc. Sheet December 31, Assets Cash Accounts receivable Prepaid insurance Office supplies Office equipment Less accumulated depreciation Total assets Liabilities Accounts payable Income taxes payable Total liabilities Stockholders' Equity Common stock Retained earnings Total stockholders' equity Total liabilities and stockholders' equity $ 7,400 2,198 200 450 $14,200 3,130 11,070 $21,318 $ 1,312 4,860 $ 7,000 8,146 $ 6,172 15,146 $21,318 4. User Insight: The effect of adjusting entries discussed By definition, adjusting entries cannot include a debit or a credit to Cash. Because adjusting entries never involve the Cash account, they never affect cash flows. That is why it is not necessary to show the effects of adjusting entries on the statement of cash flows. 127

Chapter 3, P 5. 1. Adjusting entries recorded in the general journal General Journal Page 14 Description Ref. Debit Credit a. 30 Rent Expense 514 6,000 Prepaid Rent 117 6,000 To expense one year's rent paid in advance b. 30 Insurance Expense 515 900 Prepaid Insurance 118 900 To record insurance that expired during the year c. 30 Maintenance Expense 518 5,472 Prepaid Maintenance 119 5,472 To record amount of deposit used during the year d. 30 Spare Parts Expense 516 4,647 Spare Parts 141 4,647 To record spare parts used during the year $5,655 $1,008 = $4,647 e. 30 Depreciation Expense Limousines 517 13,750 Accumulated Depreciation Limousines 143 13,750 To record depreciation on the limousines for the year $110,000 12.5% = $13,750 f. 30 Interest Expense 519 5,650 Interest Payable 213 5,650 To record accrued interest g. 30 Unearned Passenger Service Revenue 212 6,092 Passenger Service Revenue 411 6,092 To recognize passenger service revenue earned $15,000 $8,908 = $6,092 h. 30 Income Taxes Expense 520 6,625 Income Taxes Payable 214 6,625 To accrue estimated income taxes for the year 128

Chapter 3, P 5. (Continued) 2. Ledger accounts opened and balances recorded 3. Adjusting entries posted from the general journal Cash 30 4,906 Accounts Receivable Prepaid Rent 30 7,114 30 6,000 30 Adjustment J14 6,000 Prepaid Insurance 30 2,450 30 Adjustment J14 900 1,550 Account No. 111 Account No. 112 Account No. 117 Account No. 118 Prepaid Maintenance 30 6,000 30 Adjustment J14 5,472 528 Account No. 119 129

Chapter 3, P 5. (Continued) Spare Parts Account No. 141 30 5,655 30 Adjustment J14 4,647 1,008 Limousines Account No. 142 30 110,000 Accumulated Depreciation Limousines Account No. 143 30 17,500 30 Adjustment J14 13,750 31,250 Notes Payable Account No. 211 30 22,500 Unearned Passenger Service Revenue Account No. 212 30 15,000 30 Adjustment J14 6,092 8,908 Interest Payable Account No. 213 30 Adjustment J14 5,650 5,650 130

Chapter 3, P 5. (Continued) Income Taxes Payable Account No. 214 30 Adjustment J14 6,625 6,625 Common Stock Account No. 311 30 20,000 Retained Earnings 30 24,106 Dividends Account No. 313 30 10,000 Passenger Service Revenue 30 214,249 30 Adjustment J14 6,092 220,341 Gas and Oil Expense 30 44,650 Account No. 312 Account No. 411 Account No. 511 131

Chapter 3, P 5. (Continued) Salaries Expense 30 103,180 30 13,400 30 Adjustment J14 6,000 6,000 30 Adjustment J14 900 900 30 Adjustment J14 4,647 4,647 30 Adjustment J14 13,750 13,750 Account No. 512 Advertising Expense Account No. 513 Rent Expense Account No. 514 Insurance Expense Spare Parts Expense Account No. 515 Depreciation Expense Limousines Account No. 517 Account No. 516 132

Chapter 3, P 5. (Continued) Maintenance Expense 30 Adjustment J14 5,472 5,472 30 Adjustment J14 5,650 5,650 30 Adjustment J14 6,625 6,625 Account No. 518 Interest Expense Account No. 519 Income Taxes Expense Account No. 520 133

Chapter 3, P 5. (Continued) 4. Adjusted trial balance, income statement, statement of retained earnings, and balance sheet prepared Elite Livery, Inc. Adjusted Trial 30, Cash Accounts Receivable Prepaid Insurance Prepaid Maintenance Spare Parts Limousines Accumulated Depreciation Limousines Notes Payable Unearned Passenger Service Revenue Interest Payable Income Taxes Payable Common Stock Retained Earnings Dividends Passenger Service Revenue Gas and Oil Expense Salaries Expense Advertising Expense Rent Expense Insurance Expense Spare Parts Expense Depreciation Expense Limousines Maintenance Expense Interest Expense Income Taxes Expense $ 4,906 7,114 1,550 528 1,008 110,000 $ 31,250 22,500 8,908 5,650 6,625 20,000 24,106 10,000 220,341 44,650 103,180 13,400 6,000 900 4,647 13,750 5,472 5,650 6,625 $339,380 $339,380 Note: Prepaid Rent does not appear on the adjusted trial balance because it now has a zero balance. 134

Chapter 3, P 5. (Continued) Elite Livery, Inc. Income Statement For the Year Ended 30, Revenue Passenger service revenue Expenses Salaries expense Gas and oil expense Depreciation expense limousines Advertising expense Income taxes expense Rent expense Interest expense Maintenance expense Spare parts expense Insurance expense Total expenses Net income Elite Livery, Inc. Statement of Retained Earnings For the Year Ended 30, Retained earnings, 30, 2010 Net income Subtotal Less dividends Retained earnings, 30, $103,180 44,650 13,750 13,400 6,625 6,000 5,650 5,472 4,647 900 $220,341 204,274 $ 16,067 $ 24,106 16,067 $ 40,173 10,000 $ 30,173 135

Chapter 3, P 5. (Continued) Elite Livery, Inc. Sheet 30, Assets Cash Accounts receivable Prepaid insurance Prepaid maintenance Spare parts Limousines Less accumulated depreciation Total assets Liabilities Notes payable Unearned passenger service revenue Interest payable Income taxes payable Total liabilities Stockholders' Equity Common stock Retained earnings Total stockholders' equity Total liabilities and stockholders' equity $ 4,906 7,114 1,550 528 1,008 $110,000 31,250 78,750 $93,856 $ 22,500 8,908 5,650 6,625 $ 20,000 30,173 $43,683 50,173 $93,856 5. User Insight: The effect of adjustments discussed Adjusting entries affect net income on the income statement, and therefore they affect the cash flow yield. After the adjustments have been posted in the previous parts of the problem, the cash flow yield for the year has increased because the additional expenses recorded exceed the additional revenues, causing net income to decrease. 136

Chapter 3, P 6. Amount of Amount of Adjustment after Income Adjustment after Sheet Account (+ or ) Adjustment Statement Account (+ or ) Adjustment a. Office Supplies $ 783 $ 150 Office Supplies Expense + $ 783 $ 783 b. Prepaid Rent 600 200 Rent Expense + 600 600 c. Accumulated Depreciation Equipment + 416 416 Depreciation Expense Equipment + 416 416 d. Unearned Answering Service Revenue 148 740 Answering Service Revenue + 148 9,250 e. Wages Payable + 105 105 Wages Expense + 105 2,005 f. Income Taxes Payable + 1,110 1,110 Income Taxes Expense + 1,110 1,110 137

Chapter 3, P 7. 1. Adjusting entries recorded a. Nov. 30 Supplies Expense 5,171 Supplies To record supplies used $2,350 + $4,218 $1,397 = $5,171 b. 30 Insurance Expense 6,874 Prepaid Insurance To record expired insurance $4,720 1,750 [ ( $4,200 12 months ) 5 months ] 404 [ ( $7,272 36 months ) 2 months ] $6,874 c. 30 Depreciation Expense Buildings Depreciation Expense Equipment 16,000 40,000 Accumulated Depreciation Buildings Accumulated Depreciation Equipment To record annual depreciation d. 30 Unearned Service Revenue 4,650 Service Revenue To record service revenue earned on services collected in advance ( $18,600 12 months ) 3 months = $4,650 e. 30 Accounts Receivable 7,000 Service Revenue To record service revenue earned on a contract to be billed in January f. 30 Interest Expense 18,000 Interest Payable To record accrued interest on note payable 5,171 6,874 16,000 40,000 4,650 7,000 18,000 138

Chapter 3, P 7. (Continued) g. Nov. 30 Salaries Expense 10,000 Salaries Payable To record accrued salaries ( $15,000 6 days ) 4 days = $10,000 h. No entry i. 30 Income Taxes Expense 23,000 Income Taxes Payable To accrue estimated income taxes for the year 10,000 23,000 2. User Insight: Revenue recognition discussed In transaction e, $7,000 has to be recognized as revenue because services have already been provided and there is an obligation to pay for them. In transaction h, November 29 is not a recognition point because no services have been provided and there is no obligation to pay for them. 139

Chapter 3, P 8. 1. T accounts set up and balances entered 2. Adjusting entries posted to the accounts Cash Accounts Receivable Office Supplies Bal. 13,786 Bal. 24,840 Bal. 991 (a) 894 (g) 915 Bal. 97 Bal. 25,755 Prepaid Rent Bal. 1,400 (b) 500 Bal. 7,300 Bal. 900 Accounts Payable Salaries Payable Common Stock Service Revenue Rent Expense Bal. 2,600 (c) 720 Bal. 3,320 Bal. 1,820 Bal. 10,000 (d) 600 (e) 230 (f) 1,450 Bal. 2,860 (h) 2,780 Bal. 1,410 Bal. 11,000 Bal. 19,387 Bal. 15,000 Bal. 58,500 Bal. 33,400 Bal. 1,750 (f) 1,450 (e) 230 (g) 915 Bal. 33,630 Bal. 60,865 Bal. 7,700 (a) 894 (c) 720 (b) 500 Bal. 8,200 Interest Expense (d) 600 (h) 2,780 Office Equipment Notes Payable Unearned Service Revenue Retained Earnings Salaries Expense Office Supplies Expense Income Taxes Expense Accumulated Depreciation Office Equipment Interest Payable Income Taxes Payable Dividends Utilities Expense Depreciation Expense Office Equipment 140

Chapter 3, P 8. (Continued) 3. Adjusted trial balance prepared Sigma Consultants Corporation Adjusted Trial December 31, Cash Accounts Receivable Office Supplies Prepaid Rent Office Equipment Accumulated Depreciation Office Equipment Accounts Payable Notes Payable Interest Payable Salaries Payable Unearned Service Revenue Income Taxes Payable Common Stock Retained Earnings Dividends Service Revenue Salaries Expense Utilities Expense Rent Expense Office Supplies Expense Depreciation Expense Office Equipment Interest Expense Income Taxes Expense $ 13,786 25,755 97 900 7,300 $ 3,320 1,820 10,000 600 230 1,410 2,780 11,000 19,387 15,000 60,865 33,630 1,750 8,200 894 720 600 2,780 $111,412 $111,412 141

Chapter 3, P 8. (Continued) 4. User Insight: The following financial statements are affected by the adjustments: a. b. c. d. e. f. g. h. sheet, income statement, statement of retained earnings sheet, income statement, statement of retained earnings sheet, income statement, statement of retained earnings sheet, income statement, statement of retained earnings sheet, income statement, statement of retained earnings sheet, income statement, statement of retained earnings sheet, income statement, statement of retained earnings sheet, income statement, statement of retained earnings The statement of cash flows is not affected by the adjustments. 142

Chapter 3, P 9. 1. T accounts set up and balances entered 2. Adjusting entries posted to the accounts Bal. Cash Accounts Receivable Prepaid Insurance 3,650 Bal. 970 Bal. 195 (b) 130 Bal. 65 Office Supplies Bal. 610 (a) 430 Bal. 6,800 Bal. 670 Bal. 180 (c) 650 Bal. 1,320 Accounts Payable Rent Expense Bal. 590 (e) 315 Bal. 315 (f) 2,385 (d) 45 Bal. Bal. 635 Bal. 3,300 Bal. 3,117 Bal. 4,200 Bal. 20,079 Bal. 8,300 Bal. 585 (e) 315 Bal. 20,394 Telephone Expense Bal. 2,350 Bal. 411 (b) 130 (d) 45 Bal. 456 Office Supplies Expense Office Equipment Unearned Travel Fees Revenue Depreciation Expense Office Equipment (a) 430 (c) 650 (f) 2,385 Accumulated Depreciation Office Equipment Income Taxes Payable Common Stock Retained Earnings Dividends Travel Fees Revenue Office Salaries Expense Advertising Expense Insurance Expense Income Taxes Expense 143

Chapter 3, P 9. (Continued) 3. Adjusted trial balance, income statement, statement of retained earnings, and balance sheet prepared Angel Travel, Inc. Adjusted Trial December 31, Cash Accounts Receivable Prepaid Insurance Office Supplies Office Equipment Accumulated Depreciation Office Equipment Accounts Payable Income Taxes Payable Common Stock Retained Earnings Dividends Travel Fees Revenue Office Salaries Expense Advertising Expense Rent Expense Telephone Expense Insurance Expense Office Supplies Expense Depreciation Expense Office Equipment Income Taxes Expense $ 3,650 970 65 180 6,800 $ 1,320 635 2,385 3,300 3,117 4,200 20,394 8,300 585 2,350 456 130 430 650 2,385 $31,151 $31,151 Note: Unearned Travel Fees Revenue does not appear on the adjusted trial balance because it now has a zero balance. 144

Chapter 3, P 9. (Continued) Angel Travel, Inc. Income Statement For the Year Ended December 31, Revenue Travel fees revenue Expenses Office salaries expense Income taxes expense Rent expense Depreciation expense office equipment Advertising expense Telephone expense Office supplies expense Insurance expense Total expenses Net income Angel Travel, Inc. Statement of Retained Earnings For the Year Ended December 31, Retained earnings, December 31, 2010 Net income Subtotal Less dividends Retained earnings, December 31, $8,300 2,385 2,350 650 585 456 430 130 $20,394 15,286 $ 5,108 $3,117 5,108 $8,225 4,200 $4,025 145

Chapter 3, P 9. (Continued) Angel Travel, Inc. Sheet December 31, Assets Cash Accounts receivable Prepaid insurance Office supplies Office equipment Less accumulated depreciation Total assets Liabilities Accounts payable Income taxes payable Total liabilities Stockholders' Equity Common stock Retained earnings Total stockholders' equity Total liabilities and stockholders' equity $ 3,650 970 65 180 $6,800 1,320 5,480 $10,345 $ 635 2,385 $3,300 4,025 $ 3,020 7,325 $10,345 4. User Insight: The effect of adjusting entries discussed By definition, adjusting entries cannot include a debit or a credit to Cash. Because adjusting entries never involve the Cash account, they never affect cash flows. That is why it is not necessary to show the effects of adjusting entries on the statement of cash flows. 146

Chapter 3, P 10. 1. Adjusting entries recorded in the general journal General Journal Page 14 Description Ref. Debit Credit a. 30 Rent Expense 514 11,000 Prepaid Rent 117 11,000 To expense one year's rent paid in advance b. 30 Insurance Expense 515 1,400 Prepaid Insurance 118 1,400 To record insurance that expired during the year c. 30 Maintenance Expense 518 9,879 Prepaid Maintenance 119 9,879 To record amount of deposit used during the year d. 30 Spare Parts Expense 516 12,520 Spare Parts 141 12,520 To record spare parts used during the year $15,100 $2,580 = $12,520 e. 30 Depreciation Expense Vehicles 517 23,750 Accumulated Depreciation Vehicles 143 23,750 To record depreciation on the vehicles for the year $190,000 12.5% = $23,750 f. 30 Interest Expense 519 11,800 Interest Payable 213 11,800 To record accrued interest g. 30 Unearned Service Revenue 212 15,965 Service Revenue 411 15,965 To recognize service revenue earned $29,500 $13,535 = $15,965 h. 30 Income Taxes Expense 520 12,980 Income Taxes Payable 214 12,980 To accrue estimated income taxes for the year 147

Chapter 3, P 10. (Continued) 2. Ledger accounts opened and balances recorded 3. Adjusting entries posted from the general journal Cash Account No. 111 30 8,120 Accounts Receivable Prepaid Rent 30 13,270 30 11,000 30 Adjustment J14 11,000 Prepaid Insurance 30 3,700 30 Adjustment J14 1,400 2,300 Account No. 112 Account No. 117 Account No. 118 Prepaid Maintenance 30 11,000 30 Adjustment J14 9,879 1,121 Account No. 119 148

Chapter 3, P 10. (Continued) Spare Parts Account No. 141 30 15,100 30 Adjustment J14 12,520 2,580 Vehicles 30 190,000 Accumulated Depreciation Vehicles 30 25,000 30 Adjustment J14 23,750 48,750 Notes Payable Account No. 211 Account No. 142 Account No. 143 30 48,000 Unearned Service Revenue Account No. 212 30 29,500 30 Adjustment J14 15,965 13,535 Interest Payable Account No. 213 30 Adjustment J14 11,800 11,800 149

Chapter 3, P 10. (Continued) Income Taxes Payable Account No. 214 30 Adjustment J14 12,980 12,980 Common Stock Account No. 311 30 27,000 Retained Earnings 30 53,650 Service Revenue 30 419,160 30 Adjustment J14 15,965 435,125 Gas and Oil Expense 30 95,600 Account No. 312 Dividends Account No. 313 30 19,000 Account No. 411 Account No. 511 150

Chapter 3, P 10. (Continued) Salaries Expense Account No. 512 30 214,320 Advertising Expense Account No. 513 30 21,200 Rent Expense Account No. 514 30 Adjustment J14 11,000 11,000 Insurance Expense 30 Adjustment J14 1,400 1,400 Spare Parts Expense 30 Adjustment J14 12,520 12,520 30 Adjustment J14 23,750 23,750 Account No. 515 Account No. 516 Depreciation Expense Vehicles Account No. 517 151

Chapter 3, P 10. (Continued) Maintenance Expense Account No. 518 30 Adjustment J14 9,879 9,879 Interest Expense Account No. 519 30 Adjustment J14 11,800 11,800 Income Taxes Expense Account No. 520 30 Adjustment J14 12,980 12,980 152

Chapter 3, P 10. (Continued) 4. Adjusted trial balance, income statement, statement of retained earnings, and balance sheet prepared Ray Heating & Cooling, Inc. Adjusted Trial 30, Cash Accounts Receivable Prepaid Insurance Prepaid Maintenance Spare Parts Vehicles Accumulated Depreciation Vehicles Notes Payable Unearned Service Revenue Interest Payable Income Taxes Payable Common Stock Retained Earnings Dividends Service Revenue Gas and Oil Expense Salaries Expense Advertising Expense Rent Expense Insurance Expense Spare Parts Expense Depreciation Expense Vehicles Maintenance Expense Interest Expense Income Taxes Expense $ 8,120 13,270 2,300 1,121 2,580 190,000 $ 48,750 48,000 13,535 11,800 12,980 27,000 53,650 19,000 435,125 95,600 214,320 21,200 11,000 1,400 12,520 23,750 9,879 11,800 12,980 $650,840 $650,840 Note: Prepaid Rent does not appear on the adjusted trial balance because it now has a zero balance. 153

Chapter 3, P 10. (Continued) Ray Heating & Cooling, Inc. Income Statement For the Year Ended 30, Revenue Service revenue Expenses Salaries expense Gas and oil expense Depreciation expense vehicles Advertising expense Income taxes expense Spare parts expense Interest expense Rent expense Maintenance expense Insurance expense Total expenses Net income Ray Heating & Cooling, Inc. Statement of Retained Earnings For the Year Ended 30, Retained earnings, 30, 2010 Net income Subtotal Less dividends Retained earnings, 30, $214,320 95,600 23,750 21,200 12,980 12,520 11,800 11,000 9,879 1,400 $435,125 414,449 $ 20,676 $ 53,650 20,676 $ 74,326 19,000 $ 55,326 154

Chapter 3, P 10. (Continued) Ray Heating & Cooling, Inc. Sheet 30, Assets Cash Accounts receivable Prepaid insurance Prepaid maintenance Spare parts Vehicles Less accumulated depreciation Total assets Liabilities Notes payable Unearned service revenue Interest payable Income taxes payable Total liabilities Stockholders' Equity Common stock Retained earnings Total stockholders' equity Total liabilities and stockholders' equity $ 8,120 13,270 2,300 1,121 2,580 $190,000 48,750 141,250 $168,641 $ 48,000 13,535 11,800 12,980 $ 27,000 55,326 $ 86,315 82,326 $168,641 5. User Insight: The effect of adjustments discussed Adjusting entries affect net income on the income statement, and therefore they affect the cash flow yield. After the adjustments have been posted in the previous parts of the problem, the cash flow yield for the year has increased because the additional expenses recorded exceed the additional revenues, decreasing net income and thus increasing cash flow yield. 155

Lucent Technologies recognized revenue. However, collectibility was not rea- sonably assured. Therefore, Lucent Technologies violated the matching rule. Chapter 3, C 1. According to the concepts of accrual accounting and the matching rule, the accountant must estimate and record (accrue) the expenses associated with a sale even though cash may not be paid out until future years. This procedure enables management to tell whether a company is earning an income and to make informed decisions. In other words, whenever Never Flake sold a rust-prevention coating, there was an associated warranty expense that the company could expect to pay in future years. If warranty expenses had been estimated correctly in the years in which sales were made, Never Flake's management would have realized that it was either charging too little for the rust-prevention service or being too generous in the period covered by the warranty. The failure to properly estimate the warranty expense undoubtedly led to poor management decisions and, eventually, to the company's bankruptcy. Chapter 3, C 2. a. b. c. d. e. America Online (AOL) recognized advertising as an asset. However, advertising services had already been used to produce revenue in that accounting period. Therefore, AOL violated the matching rule. Future benefits are uncertain. Eclipsys recognized revenue, although it had not yet rendered the services. Therefore, Eclipsys violated the matching rule. Xerox violated the guidelines for recognition by overstating revenues. It should record revenues from the leases over the periods during which the leases are earned rather than at the date of signing. Therefore, Xerox violated the matching rule. KnowledgeWare recognized revenue, although the delivery did not occur and there was no obligation to pay. Therefore, KnowledgeWare violated the matching rule. Chapter 3, C 3. Deferred production costs result from expenditures for scenery, costumes, and stage properties that are specifically related to future productions. These costs are recorded are recorded as assets in the year in which the expenditures are made and should be expensed through an adjusting entry in the year in which the production is shown. Deferred ticket revenue (unearned revenue) relates to ticket sales for the following opera season. This amount is taken into revenue through an adjusting entry in the year in which the production is performed. These accounting policies applying policies apply accrual accounting and the matching rule to the preparation of financial statements. This enables Lyric Opera's management to assess the financial success of each year's operations and to make year-to-year comparisons of operating results. 156

Chapter 3, C 4. 1. Film and television costs defined Film and television costs consist of the cost of producing films and television programs less the amount that has been expensed. They are classified as an asset because they are the net amount associated with films and television programs that are expected to produce revenues in future years. 2. T accounts set up to record the amount spent (in millions) Cash $3,421 Film and Television Costs $3,421 3. T accounts set up to record the amount expensed (in millions) Film and Television Expense (amortization) $3,486 Film and Television Costs $3,486 4. Matching rule discussed The matching rule attempts to allocate the costs of films and television programs to the accounting periods in which the revenues associated with the costs are recognized. For example, a common way of determining the amount to expense in a given period is to multiply the cost of films and television programs times the revenues received in the current period divided by the total revenues expected to be received over the life of the films and television programs. 157

Chapter 3, C 5. 1. 2. 3. All current assets except cash can be affected by adjusting entries. Similarly, long-term assets like property and equipment can require adjustments to allocate cost to the life of the assets. Adjusting entries serve to allocate prepaid expenses that have been used in the current period and accrue revenue that has been earned. The note on property and equipment lists the various types of the company's assets and discloses their estimated useful lives. Depreciation and amortization expense appears on the CVS statement of cash flows in the lower portion of the statement where net income is reconciled to cash from operating activities. Because depreciation and amortization are operating expenses, they would also be included in operating expenses on the income statement. CVS states that its financial statements are prepared in accordance with generally accepted accounting principles (GAAP). This means that management has to make estimates and assumptions. For instance, determining the amount of depreciation expense depends on several estimates, such as the estimated lives of the assets. Chapter 3, C 6. CVS (dollars in millions): Cash Flow Yield = Cash Flows from Operating Activities Net Income 2009 $4,035.0 = = $3,696.0 1.1 or 1.1 times 2008 = $3,947.0 $3,212.0 = 1.2 or 1.2 times Southwest (dollars in millions): Cash Flow Yield = Cash Flows from Operating Activities Net Income $985 2009 = = 9.9 or 9.9 times $99 -$1,521 2008 = = -8.5 or -8.5 times $178 CVS is steadier even though its cash flow yield decreased in 2009 and was less than that of Southwest in 2009. CVS is steady even though less in 2009. 158

Chapter 3, C 7. It is not appropriate to record the cash received for the service contracts as revenues in the current year because policy coverage does not begin until the second year of ownership. This would overstate net income in the first year when cash is received. The expenses associated with these receipts will not be incurred for one year or more from the date of receipt. This would cause the net income to be under- stated in the two years the policy actually covered years 2 and 3 of ownership. To give management a clear view of how the business is doing, accrual accounting and the matching rule should be applied. This can be done by recording the cash received as deferred revenue (a liability) until the period in which the service is actually provided, which is after the regular warranty period expires. At that time, an entry would be made to debit the Unearned Service Revenue account and to credit the Service Contract Revenue account for one year's worth or a portion of a year's worth of the service contract. The remaining amount would be adjusted the following year. Students may suggest an alternative method: immediately recording the cash received as revenue, but recording the estimated cost as an expense through an adjusting entry. This method does not work as well because the service is provided in the years in which the service contract applies, not in the year in which the cash is received, and because it is difficult to estimate the amount of the future expense. To apply accrual accounting, the accountant must assume that it is possible to divide the life of the business into time periods (periodicity) and that the business will be a going concern long enough for the transactions and service contracts to be resolved. This question raises the issue of whether it would be unethical not to follow good accounting practice. In answering this question, one must recognize who benefits and who is harmed when good practices are not followed. If management's recommendation is accepted, earnings will be overstated in. Perhaps this overstatement will hurt no one. But the likelihood is that various people with stakes in the company will be hurt. For example, stockholders and creditors, such as banks, may receive an incorrect view of the company's progress and pay too high a price for stock or lend too much money to the company. One must also ask what management's stake is in this issue. Is compensation tied to net income? Could managers possibly lose their jobs if the financial results are not positive? The goal of accounting is to provide useful information based on the substance of business activities. Accounting practice should not be manipulated to achieve personal goals. If people would be hurt or unfairly rewarded because good accounting practice is not followed, it would be unethical to accept management's recommendation. 159

Chapter 3, C 8. 1. Adjusting entries prepared a. Printing Supplies Expense 22,500 Printing Supplies To record supplies used $40,000 $17,500 = $22,500 b. Depreciation Expense Equipment 25,000 Accumulated Depreciation Equipment To record depreciation on equipment c. Wages Expense 11,750 Wages Payable To record accrued wages d. Income Taxes Expense 13,500 Income Taxes Payable To record estimated income taxes e. Unearned Subscriptions Revenue 6,750 Subscriptions Revenue To recognize subscriptions fulfilled $20,250 1 / 3 = $6,750 22,500 25,000 11,750 13,500 6,750 160

Chapter 3, C 8. (Continued) 2. Financial statement amounts recast Revenues Expenses Net income Total assets Before Adjustments After $432,500 (e) 6,750 $439,250 352,500 (a) 22,500 (b) 25,000 (c) 11,750 (d) 13,500 425,250 $ 80,000 $ 14,000 (a) 22,500 $215,000 (b) 25,000 $167,500 (c) 11,750 Liabilities $ 60,000 (e) 6,750 (d) 13,500 $ 78,500 Stockholders' equity 155,000 89,000* Total liabilities and stockholders' equity $215,000 $167,500 * Total assets liabilities ($167,500 $78,500); also equals stockholders' equity before adjustment less decrease in net income ($155,000 $66,000). 3. Results discussed The performance of the company is much less favorable than Rak's original figures suggest. As a result of the adjustments, net income is $66,000 ($80,000 $14,000) less than Rak's initial determination. The lower net income means that stockholders' equity is only $89,000 ($155,000 $66,000). Instead of earning 18.5 percent on reve- nues ($80,000 $432,500) and 37.2 percent on assets ($80,000 $215,000), the firm earned only 3.2 percent on revenues ($14,000 $439,250) and 8.4 percent on assets ($14,000 $167,500). Rak's plan to issue a $62,500 dividend is probably ill-advised because it exceeds earnings by over four times and it would reduce stockholders' equity to $26,500 ($89,000 $62,500). 161

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