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EXERCISE 4-1 REPORTING INCOME: CASH VERSUS ACCRUAL ACCOUNTING
On December 31, 2003, Matt Morgan completed the first year of operations for his new
computer retail store. The following data were obtained from the company s accounting
records:
Sales to customers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $197,000
Collections from customers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145,000
Interest earned and received on savings accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,500
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98,500
Amounts paid to suppliers for inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103,000
Wages owed to employees at year-end . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,500
Wages paid to employees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000
Utility bill owed: to be paid next month. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,100
Interest due at 12/31 on loan to be paid in March of next year. . . . . . . . . . . . . . . . . . . 1,200
Amount paid for one and one-half years rent, beginning Jan. 1, 2003. . . . . . . . . . . . . 17,500
Income taxes owed at year-end . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000

1. How much net income (loss) should Matt report for the year ended December 31, 2003,
according to (a) cash-basis accounting and (b) accrual-basis accounting?
2. Which basis of accounting provides the better measure of operating results for Matt?


EXERCISE 4-2 REPORTING INCOME: CASH VERSUS ACCRUAL ACCOUNTING
On December 31, Brian Silvaggi completed the first year of operations for his new business.
The following data are available from the company s accounting records:
Sales to customers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $145,000
Collections from customers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125,000
Interest earned and received on savings accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500
Amount paid for one and one-half years rent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,600
Utility bill owed: to be paid next month. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 960
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80,000
Amount paid to suppliers for materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83,000
Wages paid to employees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47,500
Wages owed to employees at year-end . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,200
Interest due at 12/31 on a loan to be paid the middle of next year. . . . . . . . . . . . . . . . 800
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Completing the Accounting Cycle


1. How much net income (loss) should Brian report for the year ended December 31 ac-
cording to (a) cash-basis accounting and (b) accrual-basis accounting?
2. Which basis of accounting provides the better measure of operating results for Brian?

EXERCISE 4-3 CLASSIFYING ACCOUNT BALANCES
For each of the following accounts, indicate whether it would be found in the income state-
ment or in the balance sheet.
1. Cash 10. Interest Receivable 19. Sales Revenue
2. Inventory 11. Capital Stock 20. Insurance Expense
3. Salaries Expense 12. Accounts Payable 21. Machinery
4. Prepaid Salaries 13. Buildings 22. Land
5. Retained Earnings 14. Mortgage Payable 23. Salaries Payable
6. Office Supplies Expense 15. Interest Expense 24. Prepaid Insurance
7. Accounts Receivable 16. Accounts Payable 25. Notes Payable
8. Cost of Goods Sold 17. Notes Receivable 26. Dividends
9. Maintenance Expense 18. Office Supplies

EXERCISE 4-4 CLASSIFICATIONS OF ACCOUNTS REQUIRING ADJUSTING
ENTRIES
For each type of adjustment listed, indicate whether it is an unrecorded receivable, an un-
recorded liability, an unearned revenue, or a prepaid expense at December 31, 2003.
1. Property taxes that are for the year 2003, but are not to be paid until 2004.
2. Rent revenue earned during 2003, but not collected until 2004.
3. Salaries earned by employees in December 2003, but not to be paid until January 5,
2004.
4. A payment received from a customer in December 2003 for services that will not be per-
formed until February 2004.
5. An insurance premium paid on December 29, 2003, for the period January 1, 2004, to
December 31, 2004.
6. Gasoline charged on a credit card during December 2003. The bill will not be received
until January 15, 2004.
7. Interest on a certificate of deposit held during 2003. The interest will not be received un-
til January 7, 2004.
8. A deposit received on December 15, 2003, for rental of storage space. The rental period
is from January 1, 2004, to December 31, 2004.

EXERCISE 4-5 ADJUSTING ENTRIES: PREPAID EXPENSES AND UNEARNED
REVENUES
Boswell Group is a professional corporation providing management consulting services. The
company initially debits assets in recording prepaid expenses and credits liabilities in recording
unearned revenues. Give the entry that Boswell would use to record each of the following
transactions on the date it occurred. Prepare the adjusting entries needed on December 31,
2003.
1. On July 1, 2003, the company paid a three-year premium of $7,200 on an insurance
policy that is effective July 1, 2003, and expires June 30, 2006.
2. On February 1, 2003, Boswell paid its property taxes for the year February 1, 2003, to
January 31, 2004. The tax bill was $1,800.
3. On May 1, 2003, the company paid $180 for a three-year subscription to an advertising
journal. The subscription starts May 1, 2003, and expires April 30, 2006.
4. Boswell received $1,800 on September 15, 2003, in return for which the company agreed
to provide consulting services for 18 months beginning immediately.
5. Boswell rented part of its office space to Bristle Brush Company. Bristle paid $1,200 on
November 1, 2003, for the next six months rent.
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Part 1 EOC Financial Reporting and the Accounting Cycle


6. Boswell loaned $100,000 to a client. On November 1 the client paid $24,000, which
represents two years interest in advance (November 1, 2003, through October 31,
2005).

EXERCISE 4-6 ADJUSTING ENTRIES: PREPAID EXPENSES AND UNEARNED
REVENUES
Cannon Group provides computer network consulting services. The company initially debits
assets in recording prepaid expenses and credits liabilities in recording unearned revenues.
Give the appropriate entry that Cannon would use to record each of the following transac-
tions on the date it occurred. Prepare the adjusting entries needed on December 31, 2003.
(Round all numbers to the nearest dollar.)
1. On April 1, 2003, the company paid $250 for a two-year subscription to a computer
networking journal. The subscription starts April 1, 2003, and expires March 31, 2005.
2. On May 1, 2003, Cannon paid $2,300 in property taxes for the year May 1, 2003, to
April 30, 2004.
3. On June 15, 2003, Cannon received $25,000 for a contract to provide consulting ser-
vices for 18 months beginning immediately.
4. On July 1, 2003, the company paid a two-year premium of $15,000 on an insurance
policy that is effective July 1, 2003, and expires June 30, 2005.
5. Cannon rented part of its office building to Ross Graphics, LLC. Ross paid $1,500 on
September 1, 2003, for the next six months rent.
6. Cannon loaned $150,000 to a client. On October 1, 2003, the client paid $18,000 for
interest in advance (October 1, 2003, to September 30, 2004).

EXERCISE 4-7 ADJUSTING ENTRIES
Shop Rite Services is ready to prepare its financial statements for the year ended December
31, 2003. The following information can be determined by analyzing the accounts:
1. On August 1, 2003, Shop Rite received a $4,800 payment in advance for rental of office
space. The rental period is for one year beginning on the date payment was received.
Shop Rite recorded the receipt as unearned rent.
2. On March 1, 2003, Shop Rite paid its insurance agent $3,000 for the premium due on a
24-month corporate policy. Shop Rite recorded the payment as prepaid insurance.
3. Shop Rite pays its employee wages the middle of each month. The monthly payroll (ig-
noring payroll taxes) is $22,000.
4. Shop Rite received a note from a customer on June 1, 2003, as payment for services. The
amount of the note is $1,000 with interest at 12%. The note and interest will be paid on
June 1, 2005.
5. On December 20, 2003, Shop Rite received a $2,500 check for services. The transaction
was recorded as unearned revenue. By year-end, Shop Rite had completed three-fourths
of the contracted services. The rest of the services won t be completed until at least the
middle of January 2004.
6. On September 1, Shop Rite purchased $500 worth of supplies. At December 31, 2003,
one-fourth of the supplies had been used. Shop Rite initially recorded the purchase of
supplies as an asset.
Where appropriate, prepare adjusting journal entries at December 31, 2003, for each of these
items.

EXERCISE 4-8 ADJUSTING ENTRIES
Consider the following two independent situations:
1. On June 1, Brown Company received $4,800 cash for a two-year subscription to its
monthly magazine. The term of the subscription begins on June 1. Make the entry to
record the receipt of the subscription on June 1. Also make the necessary adjusting entry
at December 31. The company uses an account called Unearned Subscription Revenue.
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Completing the Accounting Cycle


2. Clark Company pays its employees every Friday for a five-day workweek. Salaries of
$200,000 are earned equally throughout the week. December 31 of the current year is a
Tuesday.
a. Make the adjusting entry at December 31.
b. Make the entry to pay the week s salaries on Friday, January 3, of the next year. As-
sume that all employees are paid for New Year s Day.

EXERCISE 4-9 ADJUSTING ENTRIES
Consider the following items for Burton Company:
1. On November 1 of the current year, Burton Company borrowed $150,000 at 8% inter-
est. As of December 31, no interest expense has been recognized.
2. On September 1 of the current year, Burton Company rented to another company some
excess space in one of its buildings. Burton Company received $18,000 cash on Septem-
ber 1. The rental period extends for six months, starting on September 1. Burton Com-
pany credited the account Unearned Rent Revenue upon receipt of the rent paid in ad-
vance.
3. At the beginning of the year, Burton Company had $900 of supplies on hand. During
the year, another $5,400 of supplies were purchased for cash and recorded in the asset ac-
count Office Supplies. At the end of the year, Burton Company determined that $1,400
of supplies remained on hand.
4. On February 1 of the current year, Burton Company loaned Dridge Company $100,000
at 9% interest. The loan amount, plus accrued interest, will be repaid in one year.
For each of the items, make the appropriate adjusting journal entry, if any, necessary in Bur-
ton Company s books as of December 31.

EXERCISE 4-10 ADJUSTING ENTRIES
Davis Company opened a Web page design business on January 1 of the current year. The
following information relates to Davis Company s operations during the current year:
1. On February 1, Davis Company rented a new office. Before moving in, it prepaid a
year s rent of $24,000 cash.
2. On March 31, Davis Company borrowed $50,000 from a local bank at 15%. The loan
is to be repaid, with interest, after one year. As of December 31, no interest payments
had yet been made.
3. Davis Company bills some of its customers in advance for its design services. During the
year Davis received $60,000 cash in advance from its customers. As of December 31,
Davis s accountant determined that 40% of that amount had not yet been earned.
4. On June 15, Davis Company purchased $1,400 of supplies for cash. On September 14,
Davis made another cash purchase of $1,100. As of December 31, Davis s accountant de-
termined that $1,700 of supplies had been used during the year.
5. Before closing its books, Davis Company found a bill for $800 from a free-lance pro-
grammer who had done work for the company in November. Davis had not yet recorded
anything in its books with respect to this bill. Davis plans to pay the bill in January of
next year.
For each of the items, make the initial entry, where appropriate, to record the transaction
and, if necessary, the adjusting entry at December 31.

EXERCISE 4-11 ANALYSIS OF ACCOUNTS
Answer the following questions:
1. If office supplies on hand amounted to $4,000 at the beginning of the period and total
purchases of office supplies during the period amounted to $22,000, determine the end-
ing balance of office supplies on hand if office supplies expense for the period amounted
to $20,000.
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Part 1 EOC Financial Reporting and the Accounting Cycle


2. If beginning and ending accounts receivable were $10,000 and $12,000, respectively, and
total sales made on account for the period amounted to $52,000, determine the amount
of cash collections from customers on account for the period.
3. Assume all rent revenues are received in advance and accounted for as unearned rent, and
beginning and ending balances of unearned rent are $3,000 and $2,500, respectively. If
total rent revenue for the period amounts to $15,000, determine the amount of rent col-
lections in advance for the period.

EXERCISE 4-12 DUPONT FRAMEWORK
The following information is for Ina Company:

2003 2002 2001

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $200,000 $160,000 $180,000
Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . 90,000 80,000 100,000
Stockholders equity . . . . . . . . . . . . . . . . . . . . . . 110,000 80,000 80,000
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800,000 600,000 600,000
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000 20,000 10,000


For the years 2001, 2002, and 2003, compute:
1. Return on equity
2. Profit margin
3. Asset turnover
4. Assets-to-equity ratio

EXERCISE 4-13 DUPONT FRAMEWORK
The numbers below are for Iffy Company and Model Company for the year 2003:

Iffy Model

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $00,120 $00,900
Accounts receivable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600 4,500
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 480 6,000
Property, plant, and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,440 15,000
Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,190 18,150
Stockholders equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,450 8,250
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000 75,000
Cost of goods sold. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,200 66,750
Wages expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 700 5,250
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 3,000


1. Compute return on equity, profit margin, asset turnover, and the assets-to-equity ratio
for both Iffy and Model.
2. Briefly explain why Iffy s return on equity is lower than Model s.

EXERCISE 4-14 DUPONT FRAMEWORK
The numbers below are for Question Company and Standard Company for the year 2003:

Question Standard

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $00,060 $00,300
Accounts receivable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600 4,000
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,400 3,650
Plant and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000 8,650
(continued)
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Completing the Accounting Cycle



Question Standard

Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $02,448 $13,280
Stockholders equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 612 3,320
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000 50,000
Cost of goods sold. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,350 36,750
Wages expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 700 3,500
Other expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,900 8,500
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50 1,250


1. Compute return on equity, profit margin, asset turnover, and the assets-to-equity ratio
for both Question and Standard.
2. Briefly explain why Question s return on equity is lower than Standard s.


EXERCISE 4-15 DUPONT FRAMEWORK FOR ANALYZING FINANCIAL
STATEMENTS
The income statement and balance sheet for the Rollins Company are provided below. Using
the DuPont framework, compute the profit margin, asset turnover, assets-to-equity ratio, and
resulting return on equity for the year 2003.


Rollins Company
Income Statement
For the Year Ended December 31, 2003

Revenue from services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $151,920
Operating expenses:
Insurance expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $05,480
Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500
Office supplies expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,960
Salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55,000 63,940
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $087,980




Rollins Company
Balance Sheet
December 31, 2003

Assets Liabilities and Owners Equity
Cash. . . . . . . . . . . . . . . . . . . . . . . $022,000 Accounts payable . . . . . . . . . . . . . $054,800
Accounts receivable . . . . . . . . . . . 40,000 Capital stock. . . . . . . . . . . . . . . . . 50,000
Notes receivable. . . . . . . . . . . . . . 12,800 Retained earnings . . . . . . . . . . . . 150,000
Machinery . . . . . . . . . . . . . . . . . . 180,000
Total liabilities
Total assets. . . . . . . . . . . . . . . . $254,800 and owners equity . . . . . . . . $254,800




EXERCISE 4-16 DUPONT FRAMEWORK FOR ANALYZING FINANCIAL
STATEMENTS
Using the income statement and balance sheet for the Jacobson and Sons Company, compute
the three components of return on equity profitability, efficiency, and leverage based on
the DuPont framework, for the year 2003.
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f188 Completing The Accounting Cycle
Part 1 EOC Financial Reporting and the Accounting Cycle



Jacobson and Sons Co.
Income Statement
For the Year Ended December 31, 2003

Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $265,000
Expenses:
Supplies expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $138,600
Salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26,700
Utilities expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,500
Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,100
Other expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,700 197,600
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $067,400




Jacobson and Sons Co.
Balance Sheet
December 31, 2003

Assets Liabilities and Owners Equity
Cash. . . . . . . . . . . . . . . . . . . . . . . $ 38,900 Accounts payable . . . . . . . . . . . . . $ 17,100
Accounts receivable . . . . . . . . . . . 31,000 Notes payable . . . . . . . . . . . . . . . 17,200
Supplies . . . . . . . . . . . . . . . . . . . . 46,300 Capital stock. . . . . . . . . . . . . . . . . 30,000
Land. . . . . . . . . . . . . . . . . . . . . . . 25,000 Retained earnings . . . . . . . . . . . . 173,600
Buildings . . . . . . . . . . . . . . . . . . . 96,700
Total liabilities
Total assets. . . . . . . . . . . . . . . . $237,900 and owners equity . . . . . . . . $237,900




EXERCISE 4-17 COMMON-SIZE BALANCE SHEET
The following data are taken from the comparative balance sheet prepared for Elison Company:

2003 2002

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 68,000 $050,000
Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86,000 80,000
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 136,000 60,000
Property, plant, and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . 182,000 110,000
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $472,000 $300,000


Sales for 2003 were $2,000,000. Sales for 2002 were $1,600,000.
1. Prepare the asset section of a common-size balance sheet for Elison Company for 2003
and 2002.
2. Overall, Elison is less efficient at using its assets to generate sales in 2003 than in 2002.
What asset or assets are responsible for this decreased efficiency?


EXERCISE 4-18 COMMON-SIZE INCOME STATEMENT
Comparative income statements for Callister Company for 2003 and 2002 are given on the
following page.
1. Prepare common-size income statements for Callister Company for 2003 and 2002.
2. The profit margin for Callister is lower in 2003 than in 2002. What expense or expenses
are causing this lower profitability?
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Completing the Accounting Cycle



2003 2002

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,600,000 $900,000
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,020,000 480,000
Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 580,000 $420,000
Selling and administrative expenses . . . . . . . . . . . . . . . . . . . . . . . 200,000 160,000
Operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 380,000 $260,000
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80,000 60,000
Income before taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 300,000 $200,000
Income tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90,000 60,000
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 210,000 $140,000



EXERCISE 4-19 REAL AND NOMINAL ACCOUNTS
Classify each of the following accounts as either a real account (R) or a nominal account (N):
1. Cash 10. Interest Expense 18. Property Tax Expense
2. Sales Revenue 11. Insurance Premiums 19. Rent Expense
3. Accounts Receivable Payable 20. Interest Payable
4. Cost of Goods Sold 12. Salaries Expense 21. Income Taxes Payable
5. Prepaid Insurance 13. Accounts Payable 22. Dividends
6. Capital Stock 14. Prepaid Salaries 23. Buildings
7. Retained Earnings 15. Utilities Expense 24. Office Supplies
8. Insurance Expense 16. Notes Payable 25. Income Tax Expense
9. Salaries Payable 17. Inventory

EXERCISE 4-20 CLOSING ENTRY
The income statement for Eriksen Enterprises for the year ended June 30, 2003, is provided.


Eriksen Enterprises
Income Statement
For the Year Ended June 30, 2003

Sales revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $187,000
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (122,000)
Selling and general expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (20,500)
Income before income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $044,500
Income tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (17,800)
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 26,700


1. Prepare a journal entry to close the accounts to Retained Earnings.
2. What problem may arise in closing the accounts if the information from the income
statement is used?

EXERCISE 4-21 CLOSING ENTRY
Revenue and expense accounts of Rushford Publishing Company for November 30, 2003, are
given as follows. Prepare a compound journal entry that will close the revenue and expense
accounts to the retained earnings account.


Debits Credits

Sales Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $250,500
Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $124,500
Salaries Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35,000
Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000
(continued)
189
f190 Completing The Accounting Cycle
Part 1 EOC Financial Reporting and the Accounting Cycle



Debits Credits

Rent Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $009,300
Insurance Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,700
Property Tax Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800
Supplies Expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000
Advertising Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000


EXERCISE 4-22 CLOSING DIVIDENDS AND PREPARING A POST-CLOSING
TRIAL BALANCE
A listing of account balances taken from the adjusted ledger account balances of Farmers Co-
Op shows the following:
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $022,580
Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56,480
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78,360
Prepaid Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,520
Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 136,000
Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28,640
Notes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000
Salaries Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,000
Taxes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,400
Unearned Rent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,200
Mortgage Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90,000
Capital Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44,000
Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000
Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68,700

All revenue and expense accounts have been closed to Retained Earnings. Dividends has not
yet been closed.
Prepare (1) the closing entry for Dividends and (2) a post-closing trial balance for De-
cember 31, 2003.

EXERCISE 4-23 CLOSING DIVIDENDS AND PREPARING A POST-CLOSING
TRIAL BALANCE
Below is a listing of account balances taken from the adjusted ledger account balances of
Goldsmith Corporation.
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $25,500
Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,000
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000
Prepaid Advertising. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,500
Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95,000
Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35,000
Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000
Wages Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000
Income Taxes Payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000
Mortgage Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55,000
Notes Payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27,500
Unearned Rent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,500
Capital Stock. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95,500
Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,500
Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51,000

All revenues and expense accounts have been closed to Retained Earnings. Dividends has not
yet been closed.
Prepare (1) the closing entry for Dividends and (2) a post-closing trial balance for De-
cember 31, 2003.
190 f191
Completing The Accounting Cycle EOC Chapter 4
Completing the Accounting Cycle



EXERCISE 4-24 ADJUSTING ENTRIES
The trial balance of Dallas Company shows the following balances, among others, on Decem-
ber 31, 2003, the end of its first fiscal year:
Rent Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 36,800
Office Supplies Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,700
Mortgage Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 130,000

Inspection of the company s records reveals that:
1. Rent revenue of $2,800 is unearned at December 31, 2003.
2. Interest of $7,800 on the mortgage is payable semiannually on March 1 and September 1.
3. Office supplies of $500 are on hand on December 31. When purchases of office supplies
were made during the year, they were charged to the office supplies expense account.
Given this information, prepare journal entries to adjust the books as of December 31, 2003.



problems

PROBLEM 4-1 CASH- AND ACCRUAL-BASIS ACCOUNTING
In the course of your examination of the books and records of Hickory Company, you find the
following data:
Salaries earned by employees in 2003 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 53,000
Salaries paid in 2003 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55,000
Total sales revenue in 2003 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 838,000
Cash collected from sales in 2003 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 900,000
Utilities expense incurred in 2003 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000
Utility bills paid in 2003 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,800
Cost of goods sold in 2003 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 532,000
Cash paid on purchases in 2003 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 411,000
Inventory at December 31, 2003. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 320,000
Tax assessment for 2003 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000
Taxes paid in 2003. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,900
Rent expense for 2003 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000
Rent paid in 2003. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,000

1. Compute Hickory s net income for 2003 using cash-basis accounting.
Required:
2. Compute Hickory s net income for 2003 using accrual-basis accounting.
3. Interpretive Question: Why is accrual-basis accounting normally used? Can you see any
opportunities for improperly reporting income under cash-basis accounting? Explain.

PROBLEM 4-2 ADJUSTING ENTRIES
The information presented below is for Sun Marketing, Inc.

a. Salaries for the period December 26, 2003, through December 31, 2003, amounted to
$14,240 and have not been recorded or paid. (Ignore payroll taxes.)
b. Interest of $6,000 is payable for three months on a 15%, $160,000 loan and has not
been recorded.
c. Rent of $24,000 was paid for six months in advance on December 1 and debited to Pre-
paid Rent.
d. Rent of $82,000 was credited to an unearned revenue account when received. Of this
amount, $33,400 is still unearned at year-end.
e. The expired portion of an insurance policy is $1,000. Prepaid Insurance was originally
debited.
191
f192 Completing The Accounting Cycle
Part 1 EOC Financial Reporting and the Accounting Cycle


f. Interest revenue of $300 from a $2,000 note has been earned but not collected or
recorded.
Required: Prepare the adjusting entries that should be made on December 31, 2003. (Omit explanations.)


PROBLEM 4-3 ADJUSTING ENTRIES
The information presented below is for Averrett Marketing, Inc.
a. Rent of $56,500 was credited to an unearned revenue account when received. Of this
amount, $24,750 is still unearned at year-end.
b. Interest revenue of $4,500 from a $65,000 note has been earned but not collected or
recorded.
c. Salaries for the period December 26, 2003, to December 31, 2003, amounted to
$11,500 and have not been recorded or paid. (Ignore payroll taxes.)
d. Interest of $8,000 is payable for September 2003 through December 2003 on a 12%,
$200,000 loan and has not been recorded.
e. The expired portion of an insurance policy is $2,150. Prepaid Insurance was originally
debited.
f. Rent of $18,000 was paid for six months in advance on November 15, 2003, and deb-
ited to Prepaid Rent.
Required: Prepare the adjusting entries that should be made on December 31, 2003. (Omit explanations.)


PROBLEM 4-4 YEAR-END ANALYSIS OF ACCOUNTS
An analysis of cash records and account balances of Wells, Inc., for 2003 is as follows:

Account Account Cash
Balances Balances Received or
Jan. 1, 2003 Dec. 31, 2003 Paid in 2003

Wages Payable . . . . . . . . . . . . . . . $2,600 $3,000
Unearned Rent . . . . . . . . . . . . . . . 4,500 5,000
Prepaid Insurance. . . . . . . . . . . . . 100 120
Paid for wages . . . . . . . . . . . . . . . $29,600
Received for rent . . . . . . . . . . . . . 12,000
Paid for insurance . . . . . . . . . . . . 720


Required: Determine the amounts that should be included on the 2003 income statement for (1) wages
expense, (2) rent revenue, and (3) insurance expense.


PROBLEM 4-5 YEAR-END ANALYSIS OF ACCOUNTS
An analysis of cash records and account balances of Computer Networking, Inc., for 2003 is as
follows:

Account Account Cash
Balances Balances Received or
Jan. 1, 2003 Dec. 31, 2003 Paid in 2003

Salaries Payable . . . . . . . . . . . . . . $10,750 $12,750
Unearned Rent . . . . . . . . . . . . . . . 23,250 26,500
Prepaid Insurance. . . . . . . . . . . . . 2,000 3,100
Paid for salaries . . . . . . . . . . . . . . $125,000
Received for rent . . . . . . . . . . . . . 64,250
Paid for insurance . . . . . . . . . . . . 12,600
192 f193
Completing The Accounting Cycle EOC Chapter 4
Completing the Accounting Cycle


Determine the amounts that should be included on the 2003 income statement for (1) salaries
Required:
expense, (2) rent revenue, and (3) insurance expense.

PROBLEM 4-6 ACCOUNT CLASSIFICATIONS AND DEBIT-CREDIT
RELATIONSHIPS
Using the format provided, for each account identify (1) whether the account is a balance sheet
(B/S) or an income statement (I/S) account; (2) whether it is an asset (A), a liability (L), an
owners equity (OE), a revenue (R), or an expense (E) account; (3) whether the account is a real
or a nominal account; (4) whether the account will be closed or left open at year-end; and
(5) whether the account normally has a debit or a credit balance. The following example is pro-
vided:


(1) (2) (3) (4) (5)
Account B/S or A, L, OE, Real or Closed Debit/
Title I/S R, E Nominal or Open Credit
Cash B/S A Real Open Debit

1. Accounts Receivable 10. Inventory 19. Wages Payable
2. Accounts Payable 11. Retained Earnings 20. Unearned Rent Revenue
3. Prepaid Insurance 12. Prepaid Rent 21. Land
4. Mortgage Payable 13. Supplies on Hand 22. Unearned Consulting
5. Rent Expense 14. Utilities Expense Fees
6. Sales Revenue 15. Income Taxes Payable 23. Interest Receivable
7. Cost of Goods Sold 16. Interest Revenue 24. Consulting Fees
8. Dividends 17. Notes Payable
9. Capital Stock 18. Income Tax Expense


PROBLEM 4-7 ANALYZING FINANCIAL STATEMENTS
Refer to the financial statements for Sports Haven Company for the year-ended December 31,
2003 (shown in the review problem for this chapter, pp. 176 177).
1. Using the DuPont framework, compute:
Required:
a. The profit margin
b. The asset turnover
c. The assets-to-equity ratio
d. The overall return on equity
2. Prepare a common-size income statement.
3. Interpretive Question: What is the value of common-size financial statements?

PROBLEM 4-8 ANALYZING FINANCIAL STATEMENTS
The income statement and the balance sheet for the Hamblin Company for the year ended De-
cember 31, 2003, are provided below.


Hamblin Company
Income Statement
For the Year Ended December 31, 2003

Sales revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $270,000
Expenses:
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $150,000
Salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45,000
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,500 205,500
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $064,500
193
f194 Completing The Accounting Cycle
Part 1 EOC Financial Reporting and the Accounting Cycle



Hamblin Company
Balance Sheet
December 31, 2003
Assets
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $049,500
Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22,500
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000
Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225,000
Total assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $312,000

Liabilities and Owners Equity
Liabilities:
Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $015,000
Owners equity:
Capital stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $202,500
Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94,500
Total owners equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 297,000
Total liabilities and owners equity . . . . . . . . . . . . . . . . . . . . . . . . $312,000



1. Using the DuPont framework, compute Hamblin s return on equity (ROE).
Required:
2. Prepare a common-size balance sheet, using total revenue as the basis for comparison.
3. Interpretive Question: Based on your analysis in (1) and (2), does Hamblin Company
appear to be in good shape?


CLOSING ENTRIES
PROBLEM 4-9
The income statement for Home Light, Inc., for the year ended December 31, 2003, is as fol-
lows:


Home Light, Inc.
Income Statement
For the Year Ended December 31, 2003
Sales revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $452,000
Less expenses:
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $363,000
Salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72,000
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,250
Office supplies expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,820
Insurance expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,930
Property tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,200
Total expenses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 460,200)
Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $0(8,200)



Dividends of $20,000 were paid on December 30, 2003.
Required:
1. Give the entry required on December 31, 2003, to properly close the income statement
accounts.
2. Give the entry required to close the dividends account at December 31, 2003.


PROBLEM 4-10 CLOSING ENTRIES
The income statement for Quality Plumbing, Inc., for the year ended December 31, 2003, is
as follows:
194 f195
Completing The Accounting Cycle EOC Chapter 4
Completing the Accounting Cycle



Quality Plumbing, Inc.
Income Statement
For the Year Ended December 31, 2003
Sales revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $623,400
Less expenses:
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $447,000
Wages expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98,350
Utilities expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,720
Insurance expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,790
Property tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,110
Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26,000
Advertising expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,830
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,300
Total expenses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 592,100
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $031,300


Dividends of $23,200 were paid on December 30, 2003.
1. Give the entry required on December 31, 2003, to properly close the income statement
Required:
accounts.
2. Give the entry required to close the dividends account at December 31, 2003.

PROBLEM 4-11 UNIFYING CONCEPTS: ADJUSTING AND CLOSING ENTRIES
The unadjusted and adjusted trial balances of White Company as of December 31, 2003, are
presented below.

White Company
Trial Balance
December 31, 2003

Unadjusted Adjusted

Debits Credits Debits Credits

Cash . . . . . . . . . . . . . . . . . . . . . . $ 21,250 $ 21,250
Accounts Receivable . . . . . . . . . . 11,250 11,250
Supplies on Hand . . . . . . . . . . . . 5,195 3,895
Prepaid Rent . . . . . . . . . . . . . . . . 17,545 7,545
Prepaid Insurance . . . . . . . . . . . . 1,985 1,100
Buildings (net). . . . . . . . . . . . . . . 95,000 95,000
Land . . . . . . . . . . . . . . . . . . . . . . 45,720 45,720
Accounts Payable . . . . . . . . . . . . $ 9,350 $009,350
Wages Payable . . . . . . . . . . . . . . 5,700
Income Taxes Payable. . . . . . . . . 580
Interest Payable. . . . . . . . . . . . . . 450 1,050
Notes Payable . . . . . . . . . . . . . . . 65,000 65,000
Capital Stock . . . . . . . . . . . . . . . . 84,320 84,320
Consulting Fees Earned. . . . . . . . 142,380 142,380
Wages Expense. . . . . . . . . . . . . . 92,335 98,035
Rent Expense . . . . . . . . . . . . . . . 10,000
Interest Expense . . . . . . . . . . . . . 3,500 4,100
Insurance Expense . . . . . . . . . . . 585 1,470
Supplies Expenses . . . . . . . . . . . 4,365 5,665
Income Tax Expense . . . . . . . . . . 2,770 3,350
Totals . . . . . . . . . . . . . . . . . . . $301,500 $301,500 $308,380 $308,380
195
f196 Completing The Accounting Cycle
Part 1 EOC Financial Reporting and the Accounting Cycle


1. Prepare the journal entries that are required to adjust the accounts at December 31,
Required:
2003.
2. Prepare the journal entry that is required to close the accounts at December 31,
2003.


PROBLEM 4-12 UNIFYING CONCEPTS: ANALYSIS OF ACCOUNTS
The bookkeeper for Careless Company accidentally pressed the wrong computer key and erased
the amount of Retained Earnings. You have been asked to analyze the following data and pro-
vide some key numbers for the board of directors meeting, which is to take place in 30 min-
utes. With the exception of Retained Earnings, the following account balances are available at
December 31, 2003.
Cash . . . . . . . . . . . . . . . . . . . . . . $122,000 Accounts Receivable . . . . . . . . . . $098,000
Furniture (net) . . . . . . . . . . . . . . 80,000 Inventory . . . . . . . . . . . . . . . . . . . 320,000
Accounts Payable . . . . . . . . . . . . 240,000 Notes Payable . . . . . . . . . . . . . . . 500,000
Land . . . . . . . . . . . . . . . . . . . . . . 520,000 Supplies on Hand . . . . . . . . . . . . 20,000
Buildings (net) . . . . . . . . . . . . . . 480,000 Capital Stock . . . . . . . . . . . . . . . . 600,000
Sales Revenue . . . . . . . . . . . . . . 830,000 Dividends . . . . . . . . . . . . . . . . . . 40,000
Salaries Expense . . . . . . . . . . . . 100,000 Retained Earnings . . . . . . . . . . . . ?
Cost of Goods Sold . . . . . . . . . . 440,000

1. Compute the amount of total assets at December 31, 2003.
Required:
2. Compute the amount of net income for the year ended December 31, 2003.
3. After all closing entries are made, what is the amount of Retained Earnings at December
31, 2003?
4. What was the beginning Retained Earnings balance at January 1, 2003?


PROBLEM 4-13 UNIFYING CONCEPTS: ANALYSIS AND CORRECTION OF
ERRORS
At the end of November 2003, the general ledger of Porridge Milling Company showed the fol-
lowing amounts:
Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $64,250
Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28,800
Owners Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62,000

The company s bookkeeper is new on the job and does not have much accounting experi-
ence. Because the bookkeeper has made numerous errors, total assets do not equal liabilities plus
owners equity. The following is a list of errors made.

a. Inventory that cost $42,000 was sold, but the entry to record cost of goods sold was not
made.
b. Credit sales of $12,100 were posted to the general ledger as $21,100. The accounts re-
ceivable were posted correctly.
c. Inventory of $12,500 was purchased on account and received before the end of Novem-
ber, but no entry to record the purchase was made until December.
d. November salaries payable of $5,000 were not recorded until paid in December.
e. Common stock was issued for $18,500 and credited to Accounts Payable.
f. Inventory purchased for $31,050 was incorrectly posted to the asset account as $13,500.
No error was made in the liability account.

Determine the correct balances of assets, liabilities, and owners equity at the end of November.
Required:


PROBLEM 4-14 UNIFYING CONCEPTS: THE ACCOUNTING CYCLE
The post-closing trial balance of Anderson Company at December 31, 2002, is shown here.
196 f197
Completing The Accounting Cycle CEO Chapter 4
Completing the Accounting Cycle



Anderson Company
Post-Closing Trial Balance
December 31, 2002

Debits Credits

Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $015,000
Accounts Receivable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000
Land. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150,000
Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $025,000
Notes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35,000
Capital Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125,000
Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000
Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $215,000 $215,000


During 2003, Anderson Company had the following transactions:
a. Inventory purchases were $80,000, all on credit (debit Inventory).
b. An additional $10,000 of capital stock was issued for cash.
c. Merchandise that cost $100,000 was sold for $180,000; $100,000 were credit sales and
the balance were cash sales. (Debit Cost of Goods Sold and credit Inventory for sale of
merchandise.)
d. The notes were paid, including $7,000 interest.
e. $105,000 was collected from customers.
f. $95,000 was paid to reduce accounts payable.
g. Salaries expense was $30,000, all paid in cash.
h. A $10,000 cash dividend was declared and paid.
Required: 1. Prepare journal entries to record each of the 2003 transactions.
2. Set up T-accounts with the proper balances at January 1, 2003, and post the journal en-
tries to the T-accounts.
3. Prepare an income statement for the year ended December 31, 2003, and a balance sheet
as of that date. Also prepare a statement of retained earnings.
4. Prepare the entries necessary to close the nominal accounts, including Dividends.
5. Post the closing entries to the ledger accounts [label (i) and (j)] and prepare a post-closing
trial balance at December 31, 2003.




competency enhancement opportunities
LLL
LLLL




Analyzing Real Company Information The Debate
International Case Cumulative Spreadsheet Project
Ethics Case Internet Search
Writing Assignment




The following additional assignments provide opportunities for students to de-
velop critical thinking, ethical perspectives, oral and written communication
197
f198 Completing The Accounting Cycle
Part 1 CEO Financial Reporting and the Accounting Cycle




skills, experience with electronic research, and teamwork through group and
business activities.




L
ANALYZING REAL COMPANY INFORMATION
Analyzing 4-1 (Microsoft)
Using MICROSOFT s 1999 annual report contained in Appendix A, answer the
following questions:
1. Microsoft discloses that as of June 30, 1999, the company had received
cash of $4.239 billion that had not been earned as of that date. Accordingly,
the company made an adjusting entry to recognize the unearned revenue.
Provide the adjusting entry that was made by Microsoft.
2. Read the note related to Microsoft s unearned revenue and determine what
this amount relates to operating systems, applications, and so forth.
3. Using the DuPont framework, determine Microsoft s return on equity.
Analyzing 4-2 (Hewlett-Packard and Compaq)
Selected financial statement information for HEWLETT-PACKARD and COM-
PAQ is given in the table below. Using this information, answer the following
questions.


(in millions) Hewlett-Packard Compaq

Assets $35,297 $27,277
Equity 18,295 14,834
Net income 3,491 569
Sales 42,370 38,525



1. Compute each firm s return on equity using the DuPont framework.
2. Identify the primary reason for the significant difference between the two
return on equity ratios.
3. Based on the ratios used in the DuPont framework, can you determine
which firm has more debt? Which ratio provided this insight?
Analyzing 4-3 (Campbell Soup)
Information from the 1999 income statement for CAMPBELL SOUP COMPANY
is shown below.


1999 1998 1997
52 52 52
(in millions) weeks weeks weeks

Net Sales $6,424 $6,696 $6,614
Costs and expenses
Cost of products sold 3,050 3,233 3,412
Marketing and selling expenses 1,634 1,518 1,370
Administrative expenses 304 300 271
Research and development expenses 66 71 68
Other expenses (Note 7) 64 64 140
Restructuring charges (Note 6) 36 262 204
Total costs and expenses 5,154 5,448 5,465
( continued)
198 f199
Completing The Accounting Cycle CEO Chapter 4
Completing the Accounting Cycle




Earnings Before Interest and Taxes $1,270 $1,248 $1,149
Interest expense (Note 8) 184 189 166
Interest income 11 14 8
Earnings before taxes 1,097 1,073 991
Taxes on earnings (Note 11) 373 384 357
Earnings from Continuing Operations 724 689 634
Earnings (Loss) from Discontinued Operations (Note 3) (18) 79
Cumulative Effect of Change in Accounting Principle (Note 4) (11)
Net Earnings $ 724 $ 660 $ 713



Using the information from the income statement, perform the following:
1. Prepare common-size income statements for 1999 and 1998. Can you iden-
tify any significant changes in expenses and revenues as a percentage of
total revenue over the two-year period?
2. Using the information from the 1999 income statement, prepare the jour-
nal entry that would be required to close the nominal accounts to Retained
Earnings.
L




INTERNATIONAL CASE
Exchange Rate Adjustments
Given the international economy in which many firms operate, it is not unusual
for companies to have transactions with companies in foreign countries. Re-
latedly, it is becoming common for some of those transactions to be denomi-
nated in a foreign currency. That is, if a company in the United States makes
a purchase from a company in Japan, it is possible that the U.S. company will
have to pay Japanese yen when the invoice comes due.
For example, suppose American, Inc., purchased inventory from Japan,
Inc., on December 15, 2002. Japan, Inc., expects to receive 1,000,000 Japanese
yen in 30 days. To record a journal entry for this purchase, you would need to
know what 1,000,000 yen are worth today. Suppose that on December 15, 2002,
one yen is worth $0.07 (this is called an exchange rate). What journal entry
would be made on American, Inc. s books?
Since exchange rates change every day, the amount of U.S. dollars to be
paid on January 15, 2003, will likely be different than the originally recorded
$70,000. In addition, to correctly state the liability on December 31, 2002, an
adjustment will be required. Suppose that at year-end, one Japanese yen is
worth $0.08. What adjusting entry would be made to reflect this change in ex-
change rates as of December 31, 2002? (HINT: The accounts being adjusted
with this journal entry will be the accounts payable account and an exchange
gain or loss.)
When the invoice is paid on January 15, 2003, it is likely that the number
of U.S. dollars required to purchase 1,000,000 Japanese yen will again have
changed. Suppose exchange rates have increased to $0.09. Provide the jour-
nal entry to pay the invoice.
L




ETHICS CASE
Do Two Wrongs Make a Right?
Jex Varner, chief financial officer of Wyndam, Inc., is involved in a meeting
with the firm s newly hired external auditors, Ernst & Price. The external au-
ditors have noted several adjusting entries that they believe should be reflected
in the current period s financial statements. Specifically, there are questions
199
f200 Completing The Accounting Cycle
Part 1 CEO Financial Reporting and the Accounting Cycle




regarding $400,000 of cash that has been received (and recorded as revenue)
but not yet earned. The auditors feel that this amount should be recognized as
a liability.
Jex counters that the firm s policy has always been to recognize revenue
when the cash is received. He states that $350,000 of cash was received in De-
cember of last year, earned in January, and no adjustment was made. To be
consistent, he continues, he doesn t believe any adjustments should be made
this year.
As a member of the external auditing team, do you agree with Jex s rea-
soning? If you think that an adjustment needs to be made, what journal entry
would you propose? What should be done about the $350,000 that has been
earned this year even though the cash was received last year?
L




WRITING ASSIGNMENT
Are Adjusting Entries More Trouble Than They Are Worth?
You are taking an introductory accounting class. You think that making regu-
lar journal entries is not too difficult, but making adjusting entries is still a bit
of a mystery. You have found that your answers to homework questions on
adjusting entries are incorrect at least half the time. You mentioned your dif-
ficulties to the other members of your study group, and they all agreed ad-
justing entries are brutal. As you and your study colleagues shared your frus-
tration with adjusting entries, the following consensus formed: adjusting entries
are more trouble than they are worth. You were selected by your study group
to pass this sentiment along to your accounting instructor. She agreed that ad-
justing entries can be difficult, but she insisted that they are worth the effort.
She has now given you the following writing assignment: write a one-page pa-
per describing the value of adjusting entries.
L




THE DEBATE
Standardizing Ratios
Up to this point in the text, you have been introduced to numerous ratios
current ratio, profit margin, return on equity, and so forth. The DuPont frame-
work introduced in this chapter provides a meaningful way of using ratios to
compare a company s performance both across time and across companies.
Using ratios for comparison purposes could be facilitated by standardizing cer-
tain ratios and requiring all companies to compute a specified set of ratios in
exactly the same way. For example, when computing a debt-to-equity ratio,
should debt include all liabilities or only long-term liabilities? Having a speci-
fied definition of what should be included in the debt number and what should
be included in the equity number might facilitate comparison.
Divide your group into two teams and defend the following positions:

Team 1 represents Standardize the Ratios. The FASB (or some other
group) should establish standards for computing ratios. All firms would be
required to compute certain ratios and include them with other financial
statement information. In addition, definitions should be provided that
specify what account balances are to be included in the numerator and de-
nominator of each ratio.
Team 2 represents Freedom of Ratios. Ratios should be neither defined
nor required by standard setters. Different financial statement users use
the information for different purposes and in different ways. Requiring ra-
tios for all companies may result in inappropriate comparisons being made.
200 f201
Completing The Accounting Cycle CEO Chapter 4
Completing the Accounting Cycle




L
CUMULATIVE SPREADSHEET PROJECT
This spreadsheet assignment is a continuation of the spreadsheet assignments
given in earlier chapters. If you completed those spreadsheets, you have a head
start on this one.
1. Refer back to the balance sheet and income statement created using the fi-
nancial statement numbers for Handyman Company for 2003 [given in part
(1) of the Cumulative Spreadsheet Project assignment in Chapter 2]. With
these historical numbers for 2003 as a starting point, Handyman wishes to
prepare a forecasted balance sheet and a forecasted income statement for
2004. In preparing the forecasted financial statements for 2004, consider
the following additional information:
a. Sales in 2004 are expected to increase by 40% over 2003 sales of $700.
b. In the forecasted balance sheet for 2004, cash, receivables, inventory,
and accounts payable will all increase at the same rate as sales (40%)
relative to 2003. These increases occur because, with the planned 40%
increase in the volume of business and no plans to significantly change
its methods of operation, Handyman will probably also experience a
40% increase in the levels of its current operating assets and liabilities.
c. In 2004, Handyman expects to acquire new property, plant, and equip-
ment costing $80.
d. Accumulated depreciation is the cumulative amount of depreciation ex-
pense that Handyman has reported over its years in business. Thus,
the forecasted amount of accumulated depreciation for 2004 can be
computed as accumulated depreciation as of the end of 2003 plus the
forecasted depreciation expense for 2004.
e. New short-term loans payable will be acquired in an amount sufficient
to make Handyman s current ratio (current assets divided by current li-
abilities) in 2004 exactly equal to 2.0.
f. No new long-term debt will be acquired in 2004.
g. No cash dividends will be paid in 2004. Remember that the amount of
retained earnings at the end of any year is the beginning retained earn-
ings amount plus net income minus dividends.
h. In this exercise, the forecasted amount of paid-in capital is the plug
figure. In other words, the forecasted balance in paid-in capital at the
end of 2004 is the amount necessary to make the forecasted balance
sheet balance such that forecasted total assets equal forecasted total
liabilities. A key reason for preparing forecasted financial statements is
to identify in advance whether any additional financing will be required.
i. The $160 in operating expenses reported in 2003 breaks down as fol-
lows: $5 depreciation expense, $155 other operating expenses.
j. In the forecasted income statement for 2004, cost of goods sold and
other operating expenses will both increase at the same rate as sales
(40%) relative to 2003. This is another way of saying that the amount
of these expenses, relative to the amount of sales, will probably stay
about the same year to year unless Handyman plans to significantly
change the way it does business.
k. The amount of Handyman s depreciation expense is determined by how
much property, plant, and equipment the company has. In 2003, Handy-
man had $5 of depreciation expense on $199 of property, plant, and
equipment, meaning that depreciation was equal to 2.5% ($5/$199) of
the amount of property, plant, and equipment. It is expected that the
same relationship will hold in 2004.
201
f202 Completing The Accounting Cycle
Part 1 CEO Financial Reporting and the Accounting Cycle




l. Interest expense depends on how much interest-bearing debt a com-
pany has. In 2003, Handyman reported interest expense of $9 on long-
term debt of $207. [Note: To simplify this exercise, we will ignore in-
terest expense on the short-term loan payable.] Because Handyman is
expected to have the same amount of long-term debt in 2004, our best
guess is that interest expense will remain the same.
m. Income tax expense is determined by how much pretax income a com-
pany has. And, the most reasonable assumption to make is that a com-
pany s tax rate, equal to income tax expense divided by pretax income,
will stay constant from year to year. Handyman s income tax rate in
2003 was 33% ($4/$12).
2. Repeat (1) assuming that forecasted sales growth in 2004 is 20% instead
of 40%. Clearly state any assumptions that you make.
L




INTERNET SEARCH
General Motors
We began this chapter with an introduction to GENERAL MOTORS; we will end
this chapter with a look at its Web site. Access GM s Web site at http://www.
gm.com. Sometimes Web addresses change, so if this address doesn t work,
access the Web site for this textbook (http://albrecht.swcollege.com) for an
updated link to GM.
Once you have located the company s Web site, answer the following ques-
tions:
1. Locate GM s financial statements. Write down the path you took to get to
the statements. In your opinion, is GM s Web site easy to navigate relative
to others you have accessed?
2. In the chapter, we computed GM s return on equity for 1999. Using the in-
formation contained in GM s most recent annual report, compute the com-
pany s return on equity using the DuPont framework. Provide these com-
putations for the two most recent periods. Using the DuPont framework,
identify the ratio(s) that highlight the reasons for any changes in return on
equity over the two-year period and compare the results with those ob-
tained from 1999.
3. Access the company s note information relating to accounting estimates.
Since these estimates result in most adjusting entries, identify who makes
these estimates and, as a result, who is responsible for making the ad-
justing entries.
4. As pointed out in the chapter, revenue is recognized when it is earned and
a promise of payment has been received. Using the note relating to rev-
enue recognition, identify when GM recognizes revenue for its various seg-
ments within the firm.
Ensuring the
Integrity of
Financial
Information

chapter



5
f5
learning objectives After studying this chapter, you should be able to:


1 Identify the types of 3 Understand the need for 5 Explain the role of the
problems that can appear in monitoring by independent Securities and Exchange
financial statements. parties. Commission in adding
credibility to financial
2 Describe the safeguards 4 Describe the role of auditors statements.
employed within a firm to and how their presence
ensure that financial affects the integrity of
statements are free from financial statements.
problems.
204 chapter f5
Ensuring The Integrity Of Financial Information


PHAR-MOR,1 a dry goods retailer based in alone. Schemers at the company kept two
Youngstown, Ohio, was founded in 1982 sets of accounting records: an official
by Mickey Monus. Within 10 years, Phar- ledger that they sometimes manipulated
Mor, with over 300 stores, was operating with false entries, called raisins, and an-
in nearly every state in the United States. other, nicknamed the cookies, where
Phar-Mor s strategy was to sell household they kept track of the false entries. They
products and prescription drugs at prices would refer to their fraud as putting
lower than those of other discount stores. raisins in the cookies.
Phar-Mor s prices were so low and its ex- For six years, some company officials
pansion was conducted so quickly that seemingly used the company as their per-
even WAL-MART, the king of discount sonal plaything, falsifying financial ledgers
prices, was nervous. Sam Walton once and allegedly raiding company coffers. Of-
said that the only company he feared at all ficers diverted more than $10 million from
in the expansion of Wal-Mart was Phar- Phar-Mor to prop up the WORLD BAS-
Mor.2 KETBALL LEAGUE (the defunct minor-
Today, with fewer than 140 stores, league basketball venture) and stole more
Phar-Mor is struggling to build a profitable than $500,000 for personal use. How could
business from the rubble of a financial a company appear in its financial state-
statement fraud that exceeded $1 billion. ments to be so profitable and yet in real-
Apparently, certain Phar-Mor executives ity be losing money? How could a com-
used financial statements showing healthy pany with a reputation as good as
profits to obtain more than $1 billion in Phar-Mor s deceive the public by misrep-
credit and capital for the company. In- resenting its profitability, and what was
vestors in Phar-Mor included SEARS, ROE- the price of this deception?
BUCK & CO., WESTINGHOUSE ELECTRIC Phar-Mor emerged from bankruptcy in
CORPORATION, and mall developer Ed- September 1995 with 102 stores. In July
ward DeBartolo Sr. (the former owner of 1999, the company had 139 stores in 24
the San Francisco 49ers). states and reported a profit from its oper-
Phar-Mor s financial statements ap- ations of $15 million. However, the debt in-
peared to present an extremely profitable curred by the company to finance its re-
setting the stage
company. In reality, the company never covery wiped out all that profit. For the
made a legitimate profit. Phar-Mor actually fiscal year ended July 3, 1999, Phar-Mor
had $238 million in pretax losses in 1992 reported a net loss of $1.6 million.




In Chapters 1 and 2, you were introduced to financial accounting and shown the outputs (financial
statements) of the financial reporting process. You learned that the balance sheet, income statement,
and statement of cash flows are reports used by organizations to summarize their financial results for
various users. In Chapters 3 and 4, the accounting cycle, the method of entering and processing fi-
nancial transaction information in the accounting records, was described. You learned that transac-
tion data are captured by journal entries, journal entry data are summarized in accounts and ledgers,
ledger information is summarized on trial balances, and trial balance information provides the ba-
sis for the balance sheet, income statement, and statement of cash flows.
In Chapters 1 through 4, the assumption was made that the financial reporting process always
works the way it should and that the resulting financial statements are accurate. In reality, however,
because of unintentional errors, as well as intentional deception or fraud (such as in the Phar-Mor
case), the resulting financial statements sometimes contain errors or omissions that can mislead in-
vestors, creditors, and other users.
In this chapter, we show how financial statements might be manipulated, and we discuss the
safeguards built into the financial reporting system to prevent these abuses. We also examine the role
that auditors play in ensuring that the financial statements fairly represent the financial performance
of the firm.

1 Most of these facts relating to Phar-Mor appeared in Gabriella Stern, Chicanery at Phar-Mor Ran Deep, Close
Look at Discounter Shows, The Wall Street Journal, January 20, 1994, p. 1.
2 Mark F. Murray, When a Client Is a Liability, Journal of Accountancy, September 1992, pp. 54 58.
205
f206 Part 1 Ensuring The Integrity Of Financial Information
Financial Reporting and the Accounting Cycle



1 THE TYPES OF PROBLEMS THAT CAN OCCUR
Identify the types of
Obviously, most businesses do not engage in the massive frauds that occurred at PHAR-MOR.
problems that can appear
in financial statements. Financial deception does not come about mainly for two reasons: (1) the vast majority of busi-
ness managers are honest, possess integrity, and would not be associated with fraudulent activ-
ity, and (2) safeguards have been built into the accounting system to prevent and detect activi-
ties that are inconsistent with the objectives of a business. These safeguards attempt to eliminate
problems from being introduced into the financial statements.
Before proceeding further, we need to make an important distinction regarding these prob-
lems. Problems in the financial statements can result for several different reasons.
1. Error results when care is not taken in recording transactions, posting transactions, sum-
marizing accounts, and so forth. Errors are not intentional and when detected are imme-
diately corrected.
2. Disagreement results when different people arrive at different conclusions based on the
same set of facts. Because accounting involves judgment and estimates, opportunities for
honest disagreements in judgment abound. These disagreements often come about because
of the different incentives that motivate those involved with producing the financial state-
ments.
3. Fraud results from intentional errors. As in the Phar-Mor case, fraudulent financial re-
porting occurs when management chooses to intentionally manipulate the financial state-
ments to serve their own purposes.
An accounting system should be designed to significantly reduce the possibility that problems,
in whatever form, will make their way into financial statements.

Types of Errors in the Reporting Process
Errors, and other problems, can occur in most stages of the accounting cycle. We will first de-
scribe the kinds of errors that can occur and then identify controls to minimize these errors.

Transactions, such as selling
ERRORS IN TRANSACTIONS AND JOURNAL ENTRIES
products or services, paying salaries, buying inventory, and paying taxes, are entered into the ac-
counting records through journal entries. For example, if $5,000 is paid to an attorney for le-
gal services, the following journal entry is made:

Legal Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000
Paid an attorney $5,000 for legal services.


An invoice from the law firm should support this entry. Errors could be introduced into
the financial reporting process if (1) the invoice from the law firm was lost and the legal expense
was not entered into the accounting records, (2) the amount entered into the accounting records
was incorrect, or (3) the accounts involved were incorrectly identified.

Even when journal entries properly summarize
ERRORS IN ACCOUNTS AND LEDGERS
legitimate transactions, errors and misstatements can be introduced into the financial records
because journal entry data are not summarized appropriately or accurately in the ledgers. Using
the previous example of paying an attorney $5,000, errors could occur at the posting stage of
the accounting cycle if the legal expense is entered in the wrong account in the ledger or if an
incorrect amount is posted to the correct account. Posting the correct amount to the wrong ex-
pense account would result in the correct total for all expenses, but individual expense account
balances would be incorrect.
A more severe error occurs at the ledger stage if amounts that should be included in asset
or liability accounts are improperly included in expense or revenue accounts, or vice versa. Ex-
206 f207
Ensuring The Integrity Of Financial Information Ensuring the Integrity of Financial Information Chapter 5


amples include (1) recording insurance expense as prepaid insurance (an asset), (2) recording
purchases of goods for resale as inventory (an asset) when they should be reported as cost of
goods sold (an expense), (3) recording a receipt of cash as revenue when it should be recorded
as unearned revenue (a liability), or (4) not reporting supplies used as an expense.

Disagreements in Judgment
Many think that the accounting profession involves exactness and precision and that the ac-
countant simply records the facts, totals the numbers, and presents unbiased results. Nothing
could be further from the truth. Accountants are constantly making judgments and estimates
regarding the past and the future. Let s return to the landscaping business that we introduced
in Chapters 3 and 4 to illustrate some of the judgments involved in the accounting process.
As your lawn care and landscaping business has become more and more successful, you have
been able to obtain bigger and better jobs. Recently, you signed a contract to provide all the
landscaping for a new condominium complex currently under construction. The terms of the
contract call for payment of one-half of the contract amount up front and the remaining one-
half upon completion. You begin working on the condominium landscaping in early Decem-
ber, but it looks as though you will not finish until well into January. To prepare financial state-
ments at the end of the calendar year, how much of the condominium contract should you
report as revenue? Well, that depends on how close to completion the job is. If you are 25%
complete, it makes sense to report 25% of the contract amount as revenue. If you are 75% com-
plete, report 75% of the contract amount as revenue. The hard part is determining how much
of the job has been completed.
Suppose you contact two landscapers (friendly competitors) and ask them to provide you
with an estimate of how complete the landscaping job is at year-end. Would it be possible for
these two people to arrive at different conclusions regarding the percentage of completion? Which
one would be right? Different people can look at the same set of facts and arrive at different
conclusions. They re not wrong, just different. In this case, the different estimates would result
in different financial statement numbers. These different numbers could make the difference be-
tween your company showing a profit or reporting a loss.
Consider another example. Most of your customers pay promptly, but some take a little
longer to pay. A few customers discontinue their lawn care service and never pay for some of
the services they received. Your problem is that when you provide a service for a customer, you
do not know if that customer will be a prompt payer, a slow payer, or a no payer. Rec-
ognizing that a certain percentage of your customers will be no payers, should you record a
receivable (and a revenue) for the full amount of every sale? As you will learn in Chapter 6, most
businesses recognize that a certain percentage of receivables will be uncollectible. How should
you arrive at the amount of your receivables that won t be collected? Is it possible that your es-
timate will be slightly off? Could different people legitimately arrive at different estimates? Of
course. These different estimates will then affect the results reported in the financial statements.

Fraudulent Financial Reporting
As mentioned previously, fraudulent financial reporting is intentional. To illustrate, consider the
journal entry made previously related to legal expense. Assume that a company s accountant em-
bezzles $5,000 and prepares the following journal entry to conceal the fraud:


Legal Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000
Paid an attorney $5,000 for legal services.


The accountant could prepare the journal entry without supporting documentation (e.g., an in-
voice) or create a fictitious invoice from a phantom law firm.
Unless someone is watching closely, the theft may go undetected. Because the accountant
made a fictitious entry to Legal Expense, the accounting records appear to be correct, and the
207
f208 Part 1 Ensuring The Integrity Of Financial Information
Financial Reporting and the Accounting Cycle



business environment essay


Manipulation of Journal Entries Adam ness wasn t as good as expected, and the dealership
F.* graduated in accounting from a lost large sums of money. To keep the business afloat,
large university. Upon graduation, he Adam began embezzling money from the bank. At first
accepted a job with one of the Big 5 he stole small amounts. As the business s cash needs
CPA firms. He worked there for three became greater, he increased the amounts until he
years, during which time he became a was stealing more than $15,000 per month. He con-
CPA and served as the in-charge audi- cealed his frauds by creating journal entries debiting
tor on a number of audit engagements. Advertising Expense and crediting Cash, as shown:
After three years, he left the CPA firm
to accept a job as controller in a small Advertising Expense. . . . . . . . . . . . . . . . . 15,000
bank. Along with two other individuals, he invested Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000
in a farm implement dealership. Unfortunately, busi- Paid monthly advertising cost.

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