<<

. 5
( 25)



>>

In the second transaction in Exhibit 11, expense account balances are transferred
to Retained Earnings. The balances of these accounts also are zero after they are trans-
ferred to Retained Earnings.
If revenues are greater than expenses for the period, Retained Earnings increases.
If revenues are less than expenses, Retained Earnings decreases. Remember that Re-
tained Earnings is an accumulation of a company™s profits. If profits are earned during
F96 SECTION F1: The Accounting Information System
95
Measuring Revenues and Expenses

Exhibit 9
Mom™s Cookie Company
Summary of Account
Account Balances
Balances for Mom™s
January 31, 2004
Cookie Company at
January 31 Account Balance
Assets:
Cash 9,300
Merchandise Inventory 1,400
Equipment 31,000
Accumulated Depreciation (520)
Total Assets 41,180
Liabilities:
Interest Payable 200
Notes Payable 30,000
Total Liabilities 30,200
Owners™ Equity:
Contributed Capital 10,000
Sales Revenue 11,400
Cost of Goods Sold (7,600)
Wages Expense (1,000)
Rent Expense (600)
Depreciation Expense (520)
Supplies Expense (300)
Utilities Expense (200)
Interest Expense (200)
Total Owners™ Equity 10,980




Exhibit 10
Mom™s Cookie Company
Income Statement for
Income Statement
Mom™s Cookie Company
For the Month Ended
January 31, 2004

Sales revenue $11,400
Cost of goods sold (7,600)
Wages expense (1,000)
Rent expense (600)
Depreciation expense (520)
Supplies expense (300)
Utilities expense (200)
Interest expense (200)
Net income $ 980




a fiscal period, Retained Earnings increases. If losses are incurred during a fiscal period
because revenues are less than expenses, Retained Earnings decreases.
Exhibit 12 illustrates the effect of closing entries on ledger account balances. Each
account contains the balance of that account prior to the closing entry. Closing entries
reset the balances of each revenue and expense account to zero and transfer these bal-
ances to Retained Earnings.
The closing entries zero out the revenue and expense account balances at the end
of a fiscal period. Consequently, the next fiscal period begins with zero balances and
accumulates revenues and expenses for the new fiscal period. The closing process also
transfers the amount of net income for a fiscal period to Retained Earnings. Keep in
mind that revenues and expenses are subcategories of owners™ equity. The closing
process transfers amounts from the income statement accounts to owners™ equity on
F97
CHAPTER F3: Measuring Revenues and Expenses
96 Measuring Revenues and Expenses

Exhibit 11 Closing Entries for January for Mom™s Cookie Company

ASSETS LIABILITIES OWNERS™ EQUITY
Other Contributed Retained
Date Accounts Cash Assets Capital Earnings
Jan. 31 Retained Earnings 11,400
Sales Revenue 11,400
Jan. 31 Retained Earnings 10,420
Cost of Goods Sold 7,600
Wages Expense 1,000
Rent Expense 600
Depreciation Expense 520
Supplies Expense 300
Utilities Expense 200
Interest Expense 200




Exhibit 12 Ledger
Effect of Closing Entries Retained Earnings Sales Revenue
on Revenue and
Expense Account Date Amount Balance Date Amount Balance
Balances 0 11,400
Jan. 31 11,400 11,400 Jan. 31 11,400 0
Jan. 31 10,420 980


Cost of Goods Sold Wages Expense

Date Amount Balance Date Amount Balance
7,600 1,000
Jan. 31 7,600 0 Jan. 31 1,000 0


Rent Expense Depreciation Expense

Date Amount Balance Date Amount Balance
600 520
Jan. 31 600 0 Jan. 31 520 0


Supplies Expense Utilities Expense

Date Amount Balance Date Amount Balance
300 200
Jan. 31 300 0 Jan. 31 200 0


Interest Expense

Date Amount Balance
200
Jan. 31 200 0
F98 SECTION F1: The Accounting Information System
97
Measuring Revenues and Expenses

the balance sheet so that the accounting equation (Assets Liabilities Owners™ Eq-
uity) balances at the end of a fiscal period.
Because revenue and expense accounts are zeroed-out at the end of a fiscal period,
they are referred to as temporary accounts. They are used during a fiscal period to col-
lect the results of operating activities. These results are transferred to Retained Earn-
ings at the end of the period. Retained Earnings and other balance sheet accounts are
referred to as permanent accounts because their balances continue to accumulate from
period to period.


Payments to Owners
Another transaction that affects the balance of Retained Earnings is a payment by a com-
pany to its owners. For example, if Maria and Stan decide to withdraw $500 from Mom™s
Cookie Company at the end of January, the transaction would be recorded like this:


ASSETS LIABILITIES OWNERS™ EQUITY
Other Contributed Retained
Date Accounts Cash Assets Capital Earnings
Jan. 31 Retained Earnings 500
Cash 500




The retained earnings account accumulates profits earned by a company for its
owners. The owners may choose to leave the profits in the company or withdraw some
of them for personal use. Amounts withdrawn reduce Retained Earnings. The balance
of Retained Earnings and Cash for Mom™s Cookie Company after the withdrawal would
be as follows:

Ledger

Retained Earnings Cash

Date Amount Balance Date Amount Balance
980 9,300
Jan. 31 500 480 Jan. 31 500 8,800




Post-Closing Account Balances
Let™s look at the effects of the closing and withdrawal entries by preparing a summary
of account balances after these entries have been posted to ledger accounts. Exhibit 13
provides a post-closing summary for Mom™s Cookie Company at the end of February.
At this point, the revenue and expense accounts have zero balances.


Balance Sheet
The balance sheet can now be prepared from the post-closing account balances. Exhibit
14 provides the balance sheet for Mom™s Cookie Company at January 31, 2004. Observe
that the amounts in the balance sheet for January 31 are those in the post-closing sum-
mary from Exhibit 13.
Along with the income statement, the balance sheet helps users determine how
well the company performed during January. From the income statement, users can
F99
CHAPTER F3: Measuring Revenues and Expenses
98 Measuring Revenues and Expenses

Exhibit 13
Mom™s Cookie Company
Post-Closing Summary
Post-Closing Summary of Account Balances
of Account Balances for
February 28, 2004
Mom™s Cookie Company
Account Balance
Assets:
Cash 8,800
Merchandise Inventory 1,400
Equipment 31,000
Accumulated Depreciation (520)
Total Assets 40,680
Liabilities:
Interest Payable 200
Notes Payable 30,000
Total Liabilities 30,200
Owners™ Equity:
Contributed Capital 10,000
Retained Earnings 480
Sales Revenue 0
Cost of Goods Sold 0
Wages Expense 0
Supplies Expense 0
Rent Expense 0
Depreciation Expense 0
Interest Expense 0
Total Owners™ Equity 10,480




Exhibit 14
Mom™s Cookie Company
January 31 Balance
Balance Sheet
Sheet for Mom™s Cookie
At January 31, 2004
Company
Assets
Cash $ 8,800
Merchandise inventory 1,400
Equipment 31,000
Accumulated depreciation (520)
Total assets $40,680
Liabilities and Owners™ Equity
Interest payable $ 200
Notes payable 30,000
Total liabilities 30,200
Contribution by owners 10,000
Retained earnings 480
Total liabilities and owners™ equity $40,680




determine the major sources of revenue and expense. From the balance sheet, they can
determine the assets controlled by the company and claims to those resources by cred-
itors and owners. When statements for additional months become available, decision
makers can compare the statements to determine whether the company is performing
better or worse over time. Users can determine how much change there is in assets,
liabilities, and owners™ equity from one month to the next.
F100 SECTION F1: The Accounting Information System
99
Measuring Revenues and Expenses

Statement of Cash Flows
A third financial statement, the statement of cash flows, also should be prepared. The
adjusting transactions described in this chapter are associated with revenue and expense
recognition, not with cash flows. Therefore, the statement of cash flows at the end of
January is almost identical to the one in Chapter F2. Exhibit 15 includes the effect of
the payment of $500 cash to owners. This payment is a financing activity.


Exhibit 15
Mom™s Cookie Company
A Statement of Cash
Statement of Cash Flows
Flows
For the Month Ended January 31, 2004

Operating Activities
Received from customers $11,400
Paid for merchandise (9,000)
Paid for wages (1,000)
Paid for rent (600)
Paid for supplies (300)
Paid for utilities (200)
Net cash flow from operating activities $ 300
Investing Activities
Paid for equipment (31,000)
Financing Activities
Received from creditors 30,000
Received from owners 10,000
Paid to owners (500)
Net cash flow from financing activities 39,500
Net cash flow for January 8,800
Cash balance, January 1 0
Cash balance, January 31 $ 8,800




SUMMARY ACCOUNTING CYCLE
OF
The procedures we have examined in this chapter are often referred to as the account-
OBJECTIVE 6
ing cycle. The accounting cycle is the process of recording, summarizing, and re-
Identify steps in the porting accounting information. As we have discussed in this chapter, the cycle consists
accounting cycle. of eight steps, as illustrated in Exhibit 16.
Once the accounting cycle is completed for one fiscal period, the accounting records
are ready to begin recording transactions for the next fiscal period. As noted in Chap-
ter F2, a fiscal period can be any time period for which managers want accounting in-
formation. Most companies prepare financial statements monthly and combine these
to prepare statements for quarterly and annual periods.


ACCOUNTING ETHICS
AND
The accounting system described in this chapter provides a way for Maria and Stan to
monitor their business activities and to make decisions about their company™s perfor-
mance. Also, it provides a means for them to communicate with creditors about the
performance of their company. An accounting system with adequate controls to ensure
reliable information is expected by stakeholders of most companies and is a legal re-
quirement for companies that sell shares of stock to the public and for many other com-
panies that are regulated by state and local authorities.
These requirements are intended to protect owners, creditors, and other stakeholders
from receiving inaccurate or improperly prepared financial information. A good account-
ing system helps ensure that all transactions are recorded properly and that stakeholders
F101
CHAPTER F3: Measuring Revenues and Expenses
100 Measuring Revenues and Expenses

Exhibit 16 Steps in the Accounting Cycle


1. Record
transactions in
journal.

8. Prepare
balance sheet 2. Post transactions
and statement to ledger accounts.
of cash flows.




3. Prepare adjusting
7. Prepare post-
entries at end of fiscal
closing summary
period and post to
of account balances.
ledger accounts.




6. Close revenue
4. Prepare summary
and expense
of account balances.
accounts to Retained
Earnings.

5. Prepare income
statement from revenue
and expense account
balances.




receive information that describes a business™s activities on a timely basis. Most businesses
are expected to comply with generally accepted accounting principles (GAAP) in prepar-
ing financial accounting information. GAAP require the use of the accrual rules and pro-
cedures described in this chapter. Making sure that a company™s accounting procedures
conform with GAAP and creating an accounting system that records and reports all trans-
actions in the appropriate fiscal periods is a major responsibility of a company™s manage-
ment. Failure to understand and implement appropriate accounting procedures is, itself,
unethical. Management is responsible for proper use of a company™s resources and for
proper reporting of its business activities. Managers who fail to take these responsibilities
seriously leave a company vulnerable to improper behavior, such as fraud and theft, that
reduces the value of the company for its owners and other stakeholders.




Case in Point
In
Economic Effects of Poor Accounting Practices
The failure of Enron Corporation™s management to properly account for and report its
business activities resulted in an understatement of the company™s liabilities and an over-
statement of profits. When the company™s bad accounting practices became apparent in
http://ingram. October 2001, creditors were unwilling to lend additional money to the company and in-
swlearning.com vestors tried to dump their stock. The value of Enron™s stock dropped rapidly, resulting
in losses of millions of dollars for owners. Many of Enron™s owners were employees of
Learn more about Enron.
the company who had invested in the company™s stock as part of their retirement plans.
Many employees lost their jobs and their retirement savings as a result of these events.
F102 SECTION F1: The Accounting Information System
101
Measuring Revenues and Expenses

Unethical behavior may occur in businesses because appropriate accounting con-
trols are not in place or are not enforced. For example, an employee sells goods to a
customer but does not record the sale and pockets the cash. This behavior leads to in-
correct accounting information. Sales Revenue, Cost of Goods Sold, Merchandise In-
ventory, and Cash are all misstated in this example. In general, unethical behavior by
employees and managers leads to misstated accounting information. Protecting a com-
pany™s accounting records and assets is an important management task. Procedures
should be in place to make it difficult for employees at all levels of the organization to
engage in unethical behavior. For example, cash registers and scanning devices help en-
sure that sales made by employees are recorded. Supervisors should compare sales
records with cash receipts to make sure cash has not been stolen. Good accounting is
the first line of defense against unethical behavior in business.




3 SELF-STUDY PROBLEM Howard Co. provided the following summary of account balances
at the end of December 2004.


Howard Co.
Summary of Account Balances
December 31, 2004

Account Balance
Cash 37,450
Accounts Receivable 2,300
Merchandise Inventory 140,000
Supplies 30,000
Equipment 75,000
Accounts Payable 2,000
Notes Payable 200,000
Investment by Owners 65,000
Retained Earnings 15,000
Sales Revenue 20,000
Cost of Goods Sold (13,000)
Wages Expense (2,000)
Depreciation Expense (750)
Interest Expense (1,500)



Required Prepare closing entries and a post-closing summary of account balances for
Howard Co.
The solution to Self-Study Problem 3 appears at the end of the chapter.




REVIEW SUMMARY of IMPORTANT CONCEPTS


1. Accrual accounting requires companies to recognize revenues in the fiscal period in
which they are earned and to recognize expenses in the period incurred.

2. Accrual accounting requires the use of accounts such as Accounts Receivable and Un-
earned Revenue to link Cash received in one period with revenues earned in another
period.

3. Accrual accounting requires the use of accounts such as Accounts Payable and Prepaid
Expenses to link Cash paid in one period with expenses incurred in another period.
F103
CHAPTER F3: Measuring Revenues and Expenses
102 Measuring Revenues and Expenses

4. Adjusting entries record revenues and expenses that occur because of the passage of
time to ensure that these revenues and expenses are recognized in the appropriate fiscal
period.

5. At the end of a fiscal period, a company closes its revenues and expense accounts to
transfer these account balances to retained earnings. The balance sheet reports retained
earnings after the accounts have been closed.

6. The accounting cycle is the process of recording transactions, preparing summaries of
account balances, closing accounts, and preparing financial statements.




DEFINE TERMS and CONCEPTS DEFINED in this CHAPTER


accounting cycle (F100) deferred expense (F87)
accounts payable (F87) deferred revenue (F87)
accounts receivable (F84) depreciation (F91)
accrual accounting (F83) general ledger (F94)
accrued expense (F87) journal (F93)
accrued liabilities (F88) ledger (F93)
accrued revenue (F87) matching principle (F89)
accumulated depreciation (F92) posting (F93)
adjusting entry (F91) prepaid expense (F88)
closing entries (F96) unearned revenue (F85)
contra account (F92)




SELF-STUDY PROBLEM SOLUTIONS
SSP3-1

ASSETS LIABILITIES OWNERS™ EQUITY
Other Contributed Retained
Date Accounts Cash Assets Capital Earnings
Jan. 15 Accounts Receivable 5,000
Sales Revenue 5,000
Jan. 15 Cost of Goods Sold 3,000
Merchandise Inventory 3,000
Jan. 23 Cash 400
Unearned Revenue 400
Jan. 25 Supplies 750
Cash 750
Jan. 31 Wages Expense 2,500
Wages Payable 2,500
Feb. 3 Wages Payable 2,500
Cash 2,500
Feb. 6 Cash 5,000
Accounts Receivable 5,000
Feb. 8 Unearned Revenue 400
Sales Revenue 400
Feb. 28 Supplies Expense 750
Supplies 750
F104 SECTION F1: The Accounting Information System
103
Measuring Revenues and Expenses

SSP3-2

ASSETS LIABILITIES OWNERS™ EQUITY
Other Contributed Retained
Date Accounts Cash Assets Capital Earnings
Oct. 31 Rent Expense 1,500
Prepaid Rent 1,500
Oct. 31 Interest Expense 800
Interest Payable 800
Oct. 31 Depreciation Expense 4,000
Accumulated Depreciation 4,000
Oct. 31 Insurance Expense 1,000
Prepaid Insurance 1,000



Note: A transaction to record the payment of interest in October for the period August, Septem-
ber, and October also would be recorded. This transaction is not an adjusting entry, however.
SSP3-3

ASSETS LIABILITIES OWNERS™ EQUITY
Other Contributed Retained
Date Accounts Cash Assets Capital Earnings
Dec. 31 Retained Earnings 20,000
Sales Revenue 20,000
Dec. 31 Retained Earnings 17,250
Cost of Goods Sold 13,000
Wages Expense 2,000
Depreciation Expense 750
Interest Expense 1,500




Howard Co.
Post-Closing Summary of Account Balances
December 31, 2004

Account Balance
Assets:
Cash 37,450
Accounts Receivable 2,300
Merchandise Inventory 140,000
Supplies 30,000
Equipment 75,000
Total Assets 284,750
Liabilities:
Accounts Payable 2,000
Notes Payable 200,000
Total Liabilities 202,000
Owners™ Equity:
Investment by Owners 65,000
Retained Earnings 17,750
Sales Revenue 0
Cost of Goods Sold 0
Wages Expense 0
Depreciation Expense 0
Interest Expense 0
Total Owners™ Equity 82,750
F105
CHAPTER F3: Measuring Revenues and Expenses
104 Measuring Revenues and Expenses


Thinking Beyond the Question
How do we know how much profit our business has earned?


At the beginning of the chapter we asked how you can know how much profit
a company has earned. This chapter described the rules and procedures of ac-
crual accounting. The rules specify when revenues and expenses should be rec-
ognized. The procedures help ensure that all revenues and expenses of a fiscal
period have been recorded and reported. Understanding accrued and deferred
revenues and expenses and adjusting and closing entries help ensure that the
proper amount of profit is reported each fiscal period and that other account-
ing information is correct.
These rules may seem relatively simple. For example, it may be easy to iden-
tify when goods are transferred to customers. However, that may not always be
the case. Suppose you agree to provide services to a customer over several fis-
cal periods. You negotiate a price with the customer that covers all of the ser-
vices to be provided. How much revenue would you recognize each fiscal period
while you are providing the services?




QUESTIONS
Why isn™t cash basis accounting the preferred method of reporting on the economic conse-
Q3-1
quences of an organization™s activities?
Obj. 1

A friend observes that “in the long run, accrual and cash flow measurements equal out to the
Q3-2
same amount. It™s only in the short run that they differ.” Do you agree or disagree? Explain.
Obj. 1

How is it possible that a company could be very profitable yet be forced to go out of business
Q3-3
because it cannot pay its bills?
Obj. 1

How does Accounts Receivable “link” Revenue and Cash?
Q3-4
Obj. 2

Where does the account Unearned Revenue appear in the financial statements? How does Un-
Q3-5
earned Revenue link Cash with Sales Revenue?
Obj. 2

Accrued revenue and deferred revenue are both accrual concepts. Explain the order in which
Q3-6
cash is received and revenue is recognized for each concept.
Obj. 2

On May 31, a company paid $900 rent for June to its landlord. Would you recommend that
Q3-7
this expenditure be presented in the end-of-May financial statements as an asset (Prepaid Rent)
Obj. 3
or as an expense (Rent Expense)? Why?
Quick Computer Company just spent $35,000 of its cash to purchase merchandise for later
Q3-8
resale to customers. Would you agree that since $35,000 of cash has been used up, a $35,000
Obj. 3
expense has been incurred in this transaction? Why or why not?
What is the difference between a subsidiary account and a control account?
Q3-9
Obj. 4

Q3-10 Why are control account balances reported in external financial statements while subsidiary
account balances are not? Are subsidiary account balances useful to anyone? Who?
Obj. 4

The textbook lists depreciation as an example of a period cost that often must be updated in
Q3-11
the accounting records at the end of a fiscal period. What other examples of period costs that
Obj. 4
must be updated at period-end can you identify? Why is it necessary to update these items?
F106 SECTION F1: The Accounting Information System
105
Measuring Revenues and Expenses

Q3-12 A friend observes that “one of the most useful pieces of information found on a balance sheet
is the current market value of assets such as buildings and land.” Do you agree or disagree? Why?
Obj. 5

Q3-13 Explain why accountants prepare a summary of general ledger account balances prior to
preparing the financial statements.
Obj. 5

Why do accountants close revenue and expense accounts prior to preparing the financial state-
Q3-14
ments?
Obj. 5

Is a payment to owners considered an expense? Explain.
Q3-15
Obj. 5

Q3-16 Why are good accounting practices the first line of defense against unethical behavior in busi-
ness?
Obj. 6

Why is an accounting system with adequate controls a legal requirement for companies that
Q3-17
sell shares of stock to the public?
Obj. 6

Accountants prepare a post-closing summary of account balances as one step of the account-
Q3-18
ing cycle. Which types of accounts have non-zero balances? Which types of accounts have zero
Obj. 6
balances?




If your instructor is using Personal Trainer in this course, you may complete online the assign-
EXERCISES ments identified by .
Write a short definition for each of the terms listed in the Terms and Concepts Defined in this
E3-1
Chapter section.
Jon Harland is a wheat farmer. He owns farm equipment and buildings that cost $600,000
E3-2
when purchased several years ago. He owes a local bank $425,000 for loans used to purchase
Obj. 1
these assets. In 2004, Jon sold $650,000 of wheat he raised during the year. He incurred op-
erating costs of $585,000 to produce the wheat. This amount included $33,750 of interest on
the bank loans and $52,500 of depreciation on the plant assets. In addition, Jon repaid $40,000
of the outstanding loan balance. The sales and all operating costs, except depreciation, were
for cash. How much net income did Jon earn in 2004? What was his net cash flow for the
year? Explain the difference.
Jeni Arrington drives for a large moving company. The company contacts Jeni when it has a
E3-3
job for her and furnishes a truck for her use. Jeni picks up the truck, drives to the customer™s
Obj. 1
home, and loads, transports, and delivers the customer™s belongings. She returns the truck to
the company and receives her pay. Jeni is paid $4.50 per mile for the job. She is responsible
for paying for her own gas, food, and lodging. Also, she must hire any helpers she needs to
load and unload the truck. Jeni traveled 2,400 miles on a recent job that was completed on
June 30. She paid $500 for gas, $116 for food, $204 for lodging, and $100 for helpers. Jeni ex-
pects to receive payment on July 5. How much did Jeni earn for the job? How much cash did
Jeni spend while providing the service? Why is there a difference in cash flow and net income?
The Hardware Shoppe sold $222,500 of goods during September. It collected $75,000 from
E3-4
these sales plus $165,000 from sales of prior months. Complete the following table:
Obj. 2



Cash Flow for Cash Flow Sales Revenue
September in Future for September

Cash from prior sales ?

Cash from September
sales ? ? ?

Total cash received in
September ?
F107
CHAPTER F3: Measuring Revenues and Expenses
106 Measuring Revenues and Expenses

E3-5 Holes ˜R™ Us, a blasting services company, has the following information available on De-
cember 31, the last day of the company™s fiscal year. Each item involves an adjusting entry that
Objs. 2, 3
must be made before financial statements can be prepared and the books closed for the year.
Show how these adjusting entries would be entered into the accounting system.
1. A $35,000 note payable, incurring 9% interest, has been outstanding for the entire year.
The note payable was properly recorded when it arose, but no entries regarding this
event have been made since.
2. A $12,000 check was received on November 2 from a tenant that subleases part of the
company™s headquarters building. The amount was in payment of rent for November,
December, and January. When the check was received, Cash was increased and Rent
Revenue was increased. (Hint: Use a liability account titled Unearned Rent.)
3. On April 1 of the current year, the company purchased a two-year fire insurance policy
for $7,200. When the policy was purchased, Cash was decreased and Prepaid Insurance
was increased for the entire amount.
4. Wear and tear on the buildings and machinery for the year is estimated to be $42,000.
Record each transaction of Rose™s Flower Shop.
E3-6
Objs. 2, 3
a. Purchased merchandise for sale on October 1 for $3,600, to be paid by October 30.
b. Sold merchandise for $900 cash on October 3. The merchandise cost Rose™s $270.
c. Sold merchandise for $1,800 on credit on October 6. The merchandise cost Rose™s $590.
d. Ordered $2,150 of merchandise on October 7 from a supplier.
e. $400 of the merchandise purchased on October 1 spoiled on October 9 and had to be
trashed, resulting in spoilage expense.
f. Paid $1,800 on October 10 to suppliers for merchandise purchased on October 1.
g. Received $1,200 on October 16 from customers for sales on October 6.
Complete the following table. Each column represents a different company. All receivables are
E3-7
collected in the year following sale.
Obj. 4


Company Company Company
A B C

Cash received from customers during 2004 $300,000 $625,000 ?

Sales revenue for 2004 $352,500 $580,000 $260,000

Accounts receivable at beginning of 2004 $31,000 ? $35,000

Accounts receivable at end of 2004 ? $85,000 $53,000



E3-8 The following information is available at December 31, the end of the fiscal year. It requires
that adjusting entries be identified and entered into the accounting system. Unless specifically
Objs. 2, 3
noted, none of this information has been previously entered into the accounting system. If
the information below were ignored, net income for the year would be $72,400.
1. Employees are owed $9,500 for wages they have earned but will not receive until the
next regular payroll distribution in five days.
2. A physical count reveals that there is $5,000 of office supplies remaining on hand at the
end of the period. The company started the year with $3,500 of office supplies recorded
in the Office Supplies Inventory account. During the year, $14,000 of office supplies
was purchased, paid for, and charged to Office Supplies Expense.
3. The basement of the building is rented out to another firm and used for storage. At
year end, the $2,000 rent for the month of December had not yet been collected.
4. At the end of the year, the company has long-term assets on which $13,600 of depreci-
ation must be recorded.
5. Earlier in the year, a bank loan was obtained and recorded in the accounting system.
Since then, interest of $5,200 has been incurred on that loan but it has not yet been
recorded or paid.
(Continued)
F108 SECTION F1: The Accounting Information System
107
Measuring Revenues and Expenses

(a) Using the spreadsheet format, show how this information would be entered into the ac-
counting system. (b) After considering the effects of all five adjusting entries, what is the proper
amount of net income that should be reported for the year?
Silberman Company transactions are listed below. Indicate the amount of revenue, expense,
E3-9
and cash flow that results from each. Use the format provided, and place the appropriate
Objs. 2, 3
amount in each section of the table. Use a separate table for each transaction.
a. $5,000 of supplies were purchased in August for cash. $1,500 of the supplies were con-
sumed in August, and $2,500 were consumed in September.
b. $15,000 of merchandise was sold in September. $6,000 of the sales were on credit.
c. Merchandise that cost Silberman $7,500 was sold in September. Silberman had paid
$5,000 for the merchandise in August. The rest was paid for in September.
d. $50,000 was borrowed in August. $2,500 will be repaid each month for 20 months be-
ginning in September. (Ignore interest.)
e. $25,000 of equipment was purchased and paid for in August. $500 of the equipment™s
revenue-generating ability was consumed in September; the remainder will be con-
sumed in the future.


Past September Future Total

Revenues

Expenses

Cash received

Cash paid




E3-10 The Get Well Medical Clinic paid $50,000 in wages during June. Of this, $5,800 was for wages
earned in May. An additional $4,200 of wages was owed to employees for services provided
Obj. 3
in June. These wages will be paid in July. Complete the following table:


Wages
Cash Flow Cash Flow Expense
for June in July for June

Cash paid for prior wages ?

Cash paid for June wages ? ? ?

Total cash paid in June for wages ?




E3-11 George Carver borrowed $150,000 on January 1 to open a peanut processing plant. Interest
on the loan is $3,750 each quarter. The first interest payment will be made on March 31. Com-
Obj. 3
plete the following table:


Total for
January February March Quarter

Cash paid for interest ? ? ? ?

Interest expense ? ? ? ?
F109
CHAPTER F3: Measuring Revenues and Expenses
108 Measuring Revenues and Expenses

E3-12 Rapid Recovery Chemical Company manufactures prescription drugs. On January 1, 2003,
the company purchased new equipment for $450,000 in cash. The company will depreci-
Obj. 3
ate the equipment over a 3-year period at $150,000 each year. Complete the following
table:


Total for
2003 2004 2005 3 Years

Cash paid for equipment ? ? ? ?

Depreciation expense ? ? ? ?



Explain the difference between cash flows each year and the amount of depreciation expense
recorded.

Tasaka Company manufactures oriental rugs. It pays utility bills at the end of the month in
E3-13
which services are received. The company received the following bills for April, May, and June,
Obj. 3
respectively: $850, $1,025, $1,150. Complete the following table:


Total for
April May June 3 Months

Cash paid for utilities ? ? ? ?

Utilities expense ? ? ? ?



When are cash and accrual basis measures different? When are they the same?

E3-14 Each of the following independent situations relates to information available on the last day
of the year. Each involves an adjustment that must be made to the accounting system before
Obj. 4
financial statements can be prepared. Show the effects of each adjusting entry on the accounting
system.
a. A $15,000 note payable, incurring 8% interest, has been outstanding the entire year.
The note payable was properly recorded when it arose.
b. A $3,000 check was received 2 months ago from a tenant that subleases part of a build-
ing. The amount was for 6 months™ rent beginning the day the check was received.
When received, the entire amount of the check was recorded in a liability account titled
Unearned Rent.
c. Exactly halfway through the year just ended, the company purchased a 2-year fire in-
surance policy for $8,000. When the policy was purchased, the entire amount was
recorded in the Prepaid Insurance account.
d. Wear and tear on the buildings and machinery for the year is estimated to be $35,000.

On August 30, 2004, Goya Co. purchased $20,000 of canvas material from a supplier, Ramirez,
E3-15
Inc., on credit. The material is cut into smaller pieces for sale to customers. Prior to the pur-
Obj. 4
chase, Goya™s merchandise inventory account had a balance of $135,000 and its accounts
payable account had a balance of $17,000. Answer each of the following questions: (a) What
subsidiary accounts are affected by the purchase and how are they affected? (b) What control
accounts are affected and how are they affected? (c) If Goya Co. prepared a balance sheet im-
mediately after recording the purchase, how would the balance sheet report the information
associated with the purchase event?

On December 31, 2004, the Washington Music Store reported net income of $1,500 and the
E3-16
following account balances.
Obj. 4
(Continued)
F110 SECTION F1: The Accounting Information System
109
Measuring Revenues and Expenses

Cash $1,375
Accounts receivable 2,100
Prepaid insurance 900
Equipment & furnishings 3,225
Less: Accumulated depreciation (500)
Accounts payable 1,100
Wages payable 1,080
Owners™ equity 4,920

After this information was prepared, the bookkeeper discovered that he had forgotten to make
two necessary adjusting entries for the year and, therefore, they were not reflected in the bal-
ances shown. Information concerning the two missing adjusting entries follows:
a. The prepaid insurance involves a 3-year fire insurance policy that was purchased (and
went into effect) on January 1, 2004. By the end of the year, a portion of the insurance
policy had been used up.
b. The wages payable does not include the wages that were owed at year-end to two work-
ers who had been temporarily assigned to work off the premises. This amount totaled
$450.
Using the following schedule, determine the correct year-end amount of (1) total assets, (2)
total liabilities, (3) owners™ equity, and (4) net income.


Assets Liabilities Equity Net Income

Year-end amounts before correction
Adjusting entry (a):
Adjusting entry (b):
Year-end corrected amounts $ $ $ $




E3-17 On December 31, 2004, Bert™s Farm Store had the following account balances in its account-
ing system. All year-end adjustments had been entered, but the books had not yet been closed.
Obj. 5



Bert™s Farm Store
Account Balances Before Closing
December 31, 2004

Account Balance Account Balance
Cash $ 700 Sales Revenue $2,200
Merchandise 2,800 Cost of Goods Sold 900
Supplies 925 Wages Expense 400
Prepaid Insurance 450 Utilities Expense 150
Equipment 3,550 Depreciation Expense 50
Accumulated Depreciation 1,750 Insurance Expense 100
Interest Payable 150 Supplies Expense 150
Notes Payable 2,000 Interest Expense 100
Owners™ Equity 4,175




a. What is the purpose of closing the books?
b. Prepare all necessary closing entries.
c. After closing, what is the amount of owners™ equity that will be reported on the balance
sheet?
F111
CHAPTER F3: Measuring Revenues and Expenses
110 Measuring Revenues and Expenses

E3-18 Constantino Company presented the following general ledger account balances for the month
ended December 31, 2005.
Obj. 5



Assets:
Cash 20,600
Accounts Receivable 2,250
Equipment 11,000
Total Assets 33,850
Liabilities:
Wages Payable 250
Payable to Internet Service 35
Notes Payable 17,000
Total Liabilities 17,285
Owners™ Equity:
Contributed Capital 13,000
Retained Earnings 1,000
Service Revenue 3,315
Rent Expense (400)
Wages Expense (315)
Internet Service Expense (35)
Total Owners™ Equity 16,565



a. Close the books for Constantino Company.
b. Prepare a post-closing summary of account balances similar to Exhibit 13.

Hydrangea Nurseries had the following general ledger balances at December 31, 2004:
E3-19
Obj. 5


Assets:
Cash 10,000
Accounts Receivable 25,000
Inventory 50,000
Prepaid Insurance 5,000
Equipment 300,000
Accumulated Depreciation (80,000)
Total Assets 310,000
Liabilities:
Accounts Payable 35,000
Notes Payable 130,000
Total Liabilities 165,000
Owners™ Equity:
Contributed Capital 90,000
Retained Earnings 45,000
Sales Revenue 300,000
Cost of Goods Sold (140,000)
Insurance Expense (5,000)
Wages Expense (75,000)
Utilities Expense (40,000)
Interest Expense (10,000)
Depreciation Expense (20,000)
Total Owners™ Equity 145,000



a. Prepare the entry to close the revenue and expense accounts at the end of the year.
b. Prepare a post-closing summary similar to Exhibit 13.
F112 SECTION F1: The Accounting Information System
111
Measuring Revenues and Expenses

E3-20 The accounting staff at Taiwan Manufacturing have prepared the following summary of ac-
count balances at year end. The balances include all transactions for the fiscal year except for
Obj. 5
closing entries.

Account Balance Account Balance
Cash $ 1,850 Sales Revenue $7,600
Merchandise 8,435 Cost of Goods Sold 2,840
Supplies 2,955 Wages Expense 1,015
Prepaid Insurance 1,375 Utilities Expense 550
Equipment 9,650 Depreciation Expense 660
Accumulated Depreciation 4,100 Insurance Expense 495
Interest Payable 425 Supplies Expense 525
Notes Payable 7,000 Interest Expense 300
Owners™ Equity 11,525

a. What is the purpose of closing the books?
b. Prepare all necessary closing entries.
c. After all closing entries are entered into the accounting system, what will be the
amount of owners™ equity reported on the balance sheet?




If your instructor is using Personal Trainer in this course, you may complete online the assign-
PROBLEMS ments identified by .

Explaining the Difference between Cash and Accrual Accounting
P3-1
Obj. 1 The accounting department at Klinger Realty sent the financial reports, as shown below, to
Robin Garrison, general manager. Attached was a note indicating that both sets of data are
based on the same set of events, which occurred during the quarter just completed. Robin was
only recently promoted to this position and is not very knowledgeable about accounting in-
formation.
After reviewing this report, Robin was somewhat disturbed because she always had
thought accounting was an exact process. How, she wondered, can there be two different re-
sults from the same set of facts? Furthermore, how could they be so different? Which one is
the “true” or “correct” report?



Klinger Realty
Results of Operating Activities
Third Quarter, 2004

Cash Basis Accrual Basis
Cash receipts/revenues:
Sales commissions $300,000 $400,000
Property management 210,000 165,000
Total $510,000 $565,000
Cash payments/expenses:
Office employee wages (53,000) (48,000)
Advertising (10,000) (90,000)
Office supplies 0 (3,400)
Depreciation”office
equipment 0 (1,800)
Rent (6,000) (6,000)
Sales staff commissions (150,000) (200,000)
Property managers™ salaries (116,000) (90,000)
Total (335,000) (439,200)
Net cash flow $175,000
Net income $125,800
F113
CHAPTER F3: Measuring Revenues and Expenses
112 Measuring Revenues and Expenses

Required Assume that you are called in to advise Ms. Garrison. Write a memo to her ex-
plaining why there can be two measures of operating results and why they differ.


Ethics and Accounting Measurement
P3-2
Obj. 1 Hardy Rock is proprietor of a jewelry store. In January, he applied for a bank loan and
was asked to submit an income statement for the past year, ending in December. Near the
end of the prior year, Hardy had purchased merchandise for resale that cost him $60,000.
He still owed $45,000 for this merchandise at year end. Half of the merchandise was sold
during the Christmas holidays for $75,000. Customers owed Hardy $50,000 for these pur-
chases at year end. Hardy included these transactions as part of his financial statements
as follows:

Added to revenues $75,000
Added to expenses 7,500
Added to net income $67,500

Hardy reasoned that because he had sold half the merchandise in December, he should report
it as revenue, though he had not received all of the cash from customers. Also, he reasoned
that because he had paid $15,000 for the merchandise by year end and had sold half of the
merchandise, he should report $7,500 of this amount as cost of goods sold.

Required What problems do you see with Hardy™s reasoning? Is there an ethical problem
with Hardy™s treatment of these transactions? What should the effect of these transactions have
been on net income?


Revenue Recognition and Accrual Accounting
P3-3
Obj. 2 Daisy Political Consultants has been in existence for many years. During the month of No-
vember, the following events occurred:
1. The owners contributed an additional $6,500 to the business to finance an expansion of
operations.
2. Consulting services totaling $11,000 were performed on credit during November and
billed to customers.
3. A loan in the amount of $25,000 was obtained from a wealthy campaign contributor.
4. Expenses in the amount of $6,000 were incurred during the month. One-third had
been paid for by month end.
5. Cash of $18,500 was collected from customers for whom services had been performed
during September and October.
6. Services totaling $4,500 were performed for customers who had paid in the previous
month for the services.

Required Daisy uses accrual basis accounting. For which of the events above should rev-
enue be recorded in November? In each case, how much revenue should be recorded? If an
event does not involve revenue, specify why not.


How Unearned Revenue Links Cash and Sales Revenue
P3-4
Obj. 2 On March 15, the Spinnaker Company received $4,000 in cash from a customer who ordered
a custom sail for her racing yacht. The company completed the sail and delivered it on April
30. The Spinnaker Company incurred costs of $2,500 in making the sail. Assume the com-
pany recorded the manufacturing costs in the Merchandise Inventory account.

Required
A. Record the transaction on March 15.
B. Record the transaction on April 30.
C. Prepare a table similar to Exhibit 2 that illustrates how Unearned Revenue links Cash
with Sales Revenue.
F114 SECTION F1: The Accounting Information System
113
Measuring Revenues and Expenses

P3-5 How Prepaid Insurance Links Cash and Insurance Expense
Obj. 3
On January 1, Taylor Manufacturing Company purchased a 12-month insurance policy for $1,200
and recorded it as Prepaid Insurance. On December 31 the bookkeeper observed the prepaid in-
surance account had a $1,200 balance representing the insurance purchased on January 1.

Required
A. Record the insurance purchase on January 1.
B. Prepare the entry required to record insurance expense for the year appropriately.
C. Prepare a table similar to Exhibit 5 that illustrates how Prepaid Insurance links Insur-
ance Expense and Cash.

Expense Recognition and Accrual Accounting
P3-6
Obj. 3 The local chapter of Helping Hands, a social service organization, had the following economic
events occur during the month of May:
1. A luncheon honoring volunteers was held at a cost of $950. By month end the bill hadn™t
been received or paid.
2. New letterhead and envelopes were printed at a cost of $625 and paid for. The new
items will not be used, however, until the old supply is exhausted sometime in June.
3. The executive director was paid her usual salary of $3,800 during May.
4. Prizes, ribbons, and awards for events upcoming in July were delivered by the supplier,
who charged $10,175. The amount was paid in cash.
5. The electric bill for April totaled $163 and was paid in full.
6. Radio, TV, and newspaper advertising related to a special fund-raising campaign ran
during May. The $7,550 cost had been paid in April.

Required Helping Hands uses accrual basis accounting. For which of the events above should
an expense be recorded in May? In each case, how much expense should be recorded? If an
event does not involve an expense, specify why not.

Converting Net Income to Cash Flow
P3-7
Objs. 1, 2, 3 Middle East Importers reports the following accrual basis information for a recent month.

Total revenue from sales to customers $90,000
Total expenses 69,000
Net income $21,000

In addition, the following account information is known:

Accounts Accounts
Receivable Payable
Beginning of month balance $ 9,000 $15,000
End of month balance 21,000 9,000

Required Determine (a) the amount of cash collected from customers during the month,
(b) the amount of cash paid out for expenses during the month, and (c) the net cash flow for
the month.

Converting Net Cash Flow to Net Income
P3-8
Objs. 1, 2, 3 Khim Lee Company reported the following cash flow information at the end of its first year
in business:

Cash received from customers $235,000
Cash paid out to suppliers of inventory (55,000)
Cash paid out to employees (77,500)
Cash paid out for advertising (12,500)
Cash paid out for taxes (30,000)
Net cash flow for the year $ 60,000
F115
CHAPTER F3: Measuring Revenues and Expenses
114 Measuring Revenues and Expenses

Also known at year end was the following:

Amounts not yet collected from customers $85,000
Amounts owed to suppliers 15,000
Wages owed to employees 22,500
Additional taxes still owed 10,000
Amount remaining in inventory 0

Required Prepare an accrual basis income statement for the company™s first year in business.


Ethics and Accounting Measurement
P3-9
Objs. 1, 2, 3 Tinker, Evers, and Chance are partners in a sports equipment megastore. Tinker keeps the ac-
counting records for the partnership because he is skilled in accounting and the other part-
ners are not. The partners have agreed that they will share equally in the company™s profits
(or losses) at the end of each year. For fiscal 2004, the first year of operations, the company
sold $7,600,000 of merchandise. Of this amount, $1,400,000 was still owed to the company
by customers at year end. The company purchased and paid for merchandise costing
$4,300,000 during 2004; $1,000,000 of this merchandise remained in inventory at year end.
The company purchased and paid for $1,400,000 of equipment during the year. The equip-
ment should have a useful life of 7 years. Thus depreciation expenses would be $200,000 each
year. Other expenses amounted to $650,000, all paid for in cash. Tinker has prepared the fol-
lowing income statement and distribution of profits for 2004:



Tinker, Evers, and Chance
Income Statement
For Year 2004

Revenues $6,200,000
Expenses:
Merchandise $4,300,000
Equipment 1,400,000
Other 650,000
Total expenses 6,350,000
Net loss $ 150,000
Distribution of net loss:
Reduction in owners™ capital:
Tinker $ 50,000
Evers 50,000
Chance 50,000
Total distribution of net loss $ 150,000




Evers and Chance are mystified by these results because they thought the company had been
performing above their expectations. Tinker assured his partners that his numbers were cor-
rect. Tinker has offered to buy out his partners, explaining that “he got ˜em into this and
should do the right thing.” Of course, the other partners will lose half of their original in-
vestment if they sell.

Required
A. What problems do you see with Tinker™s financial report?
B. Advise the other partners as to whether they should sell out. To support your advice,
prepare a revised income statement incorporating any changes you think appropriate to
support a prudent decision.
F116 SECTION F1: The Accounting Information System
115
Measuring Revenues and Expenses

Accrual versus Cash Flow
P3-10
Objs. 2, 3, 4 The Water Fun Store is a retailer of water sports products for backyard swimming pools. Dur-
ing August, the firm had the following operating activities:

Date Event
Aug. 1 Bought $5,000 of goods for resale from Pinetree Wholesalers on credit.
5 Paid $450 to the local newspaper for advertising that ran during July.
6 Paid $975 rent for the month of August.
9 Sold goods to customers for $7,350 on credit. These goods had cost the
firm $3,600.
10 Paid $3,000 to Pinetree Wholesalers in partial payment for goods
purchased August 1.
11 Collected $5,350 from goods sold on August 9.
13 Bought $9,200 of goods for resale from Stanley Company. Paid cash.
16 Paid employees for their work so far in August, $1,050.
19 Sold goods to customers on credit for $6,350. These goods had cost the
firm $2,400.
25 Collected $3,700 from the sales made on August 19.
29 Paid $975 rent for the month of September.
31 Employees had earned an additional $1,200 of wages but would not be
paid until September 1.

Required
A. Prepare a report of net cash flow from operating activities.
B. Prepare an accrual basis income statement.
C. Which statement documents a more realistic or complete picture of August™s activity?
Why?

Determining Transactions from Changes in Financial Statements
P3-11
Objs. 2, 3, 4 The Loc-Tite Correctional Facility is a private enterprise prison that contracts services to a
midwestern state. At October 1, the beginning of its fiscal year, the organization had the fol-
lowing balance sheet.



Loc-Tite Correctional Facility
Balance Sheet
at October 1

Assets: Liabilities and Owners™ Equity:
Cash $ 43,725 Accounts payable $ 28,350
Supplies 65,700 Bonds payable 450,000
Equipment 350,000 Owners™ investment 1,050,000
Building 1,400,000 Retained earnings 883,575
Accumulated
depreciation (100,000)
Land 652,500
Total $2,411,925 Total $2,411,925



During the month of October, a number of economic events occurred and were entered into
the accounting system. At the end of October, the company prepared the following financial
statements.
F117
CHAPTER F3: Measuring Revenues and Expenses
116 Measuring Revenues and Expenses


Loc-Tite Correctional Facility
Financial Statements

Balance Sheet (at Oct. 31) Income Statement (for Oct.)

Assets: Liabilities and Owners™ Equity: Revenues $810,000
Cash $ 58,725 Accounts payable $ 28,350 Expenses:
Supplies 28,200 Bonds payable 0 Supplies 37,500
Equipment 350,000 Owners™ Investment 1,050,000 Depreciation 8,625
Building 1,400,000 Retained earnings 1,302,450 Wages 345,000
Accumulated
depreciation (108,625)
Land 652,500
Total $2,380,800 Total $2,380,800 Net income $418,875




Required
A. Identify the transactions that occurred during October.
B. Prepare a schedule that explains the changes in cash balance during October.

Understanding Going Concern and Accounting Measurement
P3-12
Objs. 2, 3, 4 On March 1, Carl Caldwell started Caldwell Furniture Repair Company. He invested $2,000
of his own money, borrowed $16,000 from his father-in-law at 9% annual interest, and ob-
tained an additional $3,000, 12% loan from Maxibank. He purchased $15,000 of tools and
equipment (some new, some used) and bought $5,200 of supplies such as paints, resins, and
glue, all for cash. He rented a shop at a local business park by paying $3,600 in advance for
the months of March, April, and May. During March he performed repairs totaling $7,600
and used up $2,400 of supplies. Of the repair services performed, 75% were paid for in cash
by the end of the month and the balance was expected to be collected in April. Carl estimated
that wear and tear on the equipment and tools during March was $250. On March 31, he owed
$332 to the electric company and $78 to the water company for services consumed. Also on
that date, he paid interest totaling $150 on the two loans.

Required
A. Prepare an income statement for Caldwell Furniture Repair for the month of March.
B. Prepare a separate schedule that explains the changes in cash balance during March.
C. Is the transformation cycle complete or incomplete at the end of March? Explain your
answer.

Accrual versus Cash Flow
P3-13
Objs. 2, 3, 4 Consider each of the five independent situations below.
1. Asia Tea Company purchased a 3-month property insurance policy on March 1 at a
cost of $3,600. The insurance became effective immediately although payment was due
and paid 45 days later.
2. On February 1, Big Bang Chemical Company signed a contract with a customer. Big
Bang agreed to deliver each month, for 3 months, goods priced at $7,500. The first de-
livery was made on April 1. The customer paid $22,500 for these goods on May 15.
3. Turning Tire Company borrowed $15,000 from a bank on February 1. Terms of repay-
ment are that $1,000 of the principal amount must be repaid on the first day of each
following month. In addition, interest at 2% per month on the unpaid balance must
accompany each payment.
4. Bureaucrats, Inc. consumes large amounts of office supplies. On February 1, a $10,000
order of supplies was received and paid for. 60% of these supplies were used in March
and the rest were used in April. On April 20, a $12,000 order of office supplies was re-
ceived. The invoice for these goods was paid in May. 30% of these goods were con-
sumed in May and the rest were consumed in June.
(Continued)
F118 SECTION F1: The Accounting Information System
117
Measuring Revenues and Expenses

5. Sales at the High-Price Furniture Store totaled $45,000 for the month of February. Of
this amount, 20% was cash sales, 40% was collected during March, 30% during April,
and 10% during May.

Required
A. Determine the proper amount of revenue, expense, and cash flow that should be en-
tered into the accounting system during each month shown. Use the format shown be-
low. The first event is completed as an example.
B. What does this information suggest to you about the pattern in which accrual-based
measures are recognized versus cash-based measures?
C. What does this suggest to you about a manager™s need for both accrual information
and cash flow information?


Revenue,
Expense, or Month of Month of Month of Month of Month of
Event Cash Flow? February March April May June

1. Expense -0- $1,200 $1,200 $1,200 -0-
Cash Flow -0- -0- 3,600 -0- -0-

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