chapter 3 adjusting the accounts · copyright © 2013 john wiley & sons, inc. weygandt,...

Copyright © 2013 John Wiley & Sons, Inc. Weygandt, Accounting Principles, 11/e, Instructor’s Manual (For Instructor Use Only) 3-1

CHAPTER 3

ADJUSTING THE ACCOUNTS

LEARNING OBJECTIVES

1. EXPLAIN THE TIME PERIOD ASSUMPTION.

2. EXPLAIN THE ACCRUAL BASIS OF ACCOUNTING.

3. EXPLAIN THE REASONS FOR ADJUSTING ENTRIES AND IDENTIFY THE MAJOR TYPES OF ADJUSTING ENTRIES.

4. PREPARE ADJUSTING ENTRIES FOR DEFERRALS.

5. PREPARE ADJUSTING ENTRIES FOR ACCRUALS.

6. DESCRIBE THE NATURE AND PURPOSE OF AN ADJUSTED TRIAL BALANCE.

*7. PREPARE ADJUSTING ENTRIES FOR THE ALTERNA-TIVE TREATMENT OF DEFERRALS.

*8. DISCUSS FINANCIAL REPORTING CONCEPTS.

3-2 Copyright © 2013 John Wiley & Sons, Inc. Weygandt, Accounting Principles, 11/e, Instructor’s Manual (For Instructor Use Only)

CHAPTER REVIEW

Timing Issues 1. (L.O. 1) The time period (or periodicity) assumption assumes that the economic life of a

business can be divided into artificial time periods. 2. Accounting time periods are generally a month, a quarter, or a year. An accounting time period

that is one year in length is a fiscal year.

Accrual Basis of Accounting 3. (L.O. 2) The revenue recognition and expense recognition principles are used under the accrual

basis of accounting. Under cash basis accounting, revenue is recorded only when cash is received and expenses are recorded only when paid.

4. Generally accepted accounting principles require accrual basis accounting rather than cash basis

accounting because the cash basis of accounting often leads to misleading financial statements.

Revenue Recognition Principle 5. The revenue recognition principle requires that companies recognize revenue in the accounting

period in which the performance obligation is satisfied.

The Expense Recognition Principle 6. The expense recognition principle requires that efforts (expenses) be matched with results

(revenues).

Adjusting Entries 7. (L.O. 3) Adjusting entries are made in order for: a. Revenues to be recorded in the period in which services are performed, and for expenses to

be recognized in the period in which they are incurred. b. The revenue recognition and expense recognition principles are followed. 8. Adjusting entries are required every time financial statements are prepared. Adjusting entries can

be classified as (a) deferrals (prepaid expenses or unearned revenues) or (b) accruals (accrued revenues or accrued expenses).

Deferrals 9. (L.O. 4) Prepaid expenses are expenses paid in cash before they are used or consumed. a. Prepaid expenses expire with the passage of time or through use and consumption. b. An asset-expense account relationship exists with prepaid expenses. c. Prior to adjustment, assets are overstated and expenses are understated. d. The adjusting entry results in a debit to an expense account and a credit to an asset account. e. Examples of prepaid expenses include supplies, insurance, and depreciation. f. To illustrate a prepaid adjusting entry, assume on October 1, Kubitz Company pays $2,400

cash to Sandy Insurance Co. for a one-year insurance policy effective October 1. The ad-justing entry at October 31 is:

Insurance Expense ($2,400 X 1/12) ................................... 200 Prepaid Insurance ....................................................... 200


10. Depreciation is the process of allocating the cost of an asset to expense over its useful life in a rational and systematic manner.

a. The purchase of equipment or a building is viewed as a long-term prepayment of services and, therefore, is allocated in the same manner as other prepaid expenses.

b. Depreciation is an estimate rather than a factual measurement of the cost that has expired. c. In recording depreciation, Depreciation Expense is debited and a contra asset account,

Accumulated Depreciation—Equipment, is credited. d. In the balance sheet, Accumulated Depreciation is offset against the asset account. The

difference between the cost of the asset and its related accumulated depreciation is referred to as the book value of the asset.

e. To illustrate an adjusting entry for depreciation, assume Resch Co. purchases equipment for $6,000 cash on January 1, 2014. Assuming that annual depreciation is $1,200, the adjusting entry at December 31, 2014 is:

Depreciation Expense ................................................ 1,200 Accumulated Depreciation Equipment ............. 1,200

11. Unearned revenues are cash received before services are performed. a. Unearned revenues are subsequently recognized by performing the service for a customer. b. A liability-revenue account relationship exists with unearned revenues. c. Prior to adjustment, liabilities are overstated and revenues are understated. d. The adjusting entry results in a debit to a liability account and a credit to a revenue account. e. Examples of unearned revenues include rent, magazine subscriptions, and customer deposits

for future service. f. To illustrate an unearned revenue adjusting entry, assume on October 1, Schoen Co. receives

$3,000 cash from a renter in payment of monthly rent for the period October through December. At October 31, the adjusting entry to record the rent earned in October is:

Unearned Rent Revenue ............................................. 1,000 Rent Revenue ($3,000 X 1/3) ............................. 1,000

Accruals

12. (L.O. 5) Accrued revenues are revenues for services performed but not yet received in cash or recorded.

a. Accrued revenues may accumulate with the passing of time as in the case of interest and rent, or through services performed but for which payment has not been collected.

b. An asset-revenue account relationship exists with accrued revenues. c. Prior to adjustment, both assets and revenues are understated. d. The adjusting entry results in an increase (a debit) to an asset account and an increase

(a credit) to a revenue account. e. To illustrate an accrued revenue adjusting entry, assume in October, Mayer, a dentist, performs

$800 of services for patients for which payment has not been collected. The adjusting entry at October 31 is:

Accounts Receivable ................................................... 800 Service Revenue ................................................ 800 13. Accrued expenses are expenses incurred but not yet paid in cash or recorded. a. Accrued expenses result from the same causes as accrued revenues and include interest,

rent, taxes, and salaries. b. A liability-expense account relationship exists with accrued expenses. c. Prior to adjustment, both liabilities and expenses are understated.


d. The adjusting entry results in an increase (a debit) to an expense account and an increase (a credit) to a liability account.

e. To illustrate an accrued expense adjusting entry, assume Schwenk Company incurs salaries and wages of $4,000 during the last week of October that will be paid in November. The adjusting entry on October 31 is:

Salaries and Wages Expense ..................................... 4,000 Salaries and Wages Payable ............................. 4,000 14. Each adjusting entry affects one balance sheet account and one income statement account.

Adjusted Trial Balance 15. (L.O. 6) After all adjusting entries have been journalized and posted an adjusted trial balance

is prepared. This trial balance shows the balances of all accounts, including those that have been adjusted, at the end of the accounting period.

16. The purpose of an adjusted trial balance is to prove the equality of the total debit balances and

the total credit balances in the ledger after all adjustments have been made.

17. The accounts in the adjusted trial balance contain all data that are needed for the preparation of financial statements.

Alternative Treatment *18. (L.O. 7) Under the alternative treatment, at the time an expense is prepaid, an expense account

is debited, and when unearned revenues are received a revenue account is credited. *19. The alternative treatment of prepaid expenses and unearned revenues has the same effect on the

financial statements as the procedures described in the chapter. *20. When a prepaid expense is initially debited to an expense account, a. No adjusting entry will be required if the prepayment is fully expired or consumed before the

next financial statement date. b. If the prepayment is not fully expired or consumed, an adjusting entry is required. c. Prior to adjustment an expense account is overstated and an asset account is understated. d. The adjusting entry results in a debit (increase) to an asset account and a credit (decrease)

to an expense account. e. To illustrate the adjusting entry, assume Gonzalez Company purchases $1,200 of supplies

and debits Supplies Expense. At the next financial statement date, $300 of supplies are on hand. The adjusting entry is:

Supplies ..................................................................... 300 Supplies Expense .............................................. 300 *21. When an unearned revenue is initially credited to a revenue account, the procedures are similar to

those described above for prepaid expenses. In this case, however, a. Prior to adjustment, a revenue account is overstated and a liability account is understated. b. The adjusting entry results in a debit to a revenue account and a credit to a liability account.


Financial Reporting Concepts *22. (L.O.8) According to the FASB, to be useful, information should have two fundamental

qualities: relevance and faithful representation. Accounting information has relevance if it makes a difference in a business decision. If relevant, accounting information has predictive value and confirmatory value. In addition, materiality is a company-specific aspect of relevance.

Faithful representation means that accounting information accurately depicts what really

happened. To provide this, information must be complete, neutral and free from error. *23. Accounting information is comparable when different companies use the same accounting

principles. Accounting information is consistent when one company uses the same accounting principles and methods from year to year. If a company changes principles in order to produce more meaningful information, then it must disclose the change in the notes to the financial statements.

*24. To be relevant, accounting information must be presented on a timely basis, meaning that it must

be available to decision makers before it loses its capacity to influence decisions. Accounting information is understandable if it is presented in a clear and concise fashion so that a reasonably informed user can interpret and use it. Accounting information is verifiable if it can be proven to be free from error.

*25. The monetary unit assumption states that only those things that can be expressed in monetary

terms are included in the accounting records. The economic entity assumption states that every economic entity should be separately identified and accounted for.

*26. The periodicity assumption states that the life of a business can be divided into artificial time

periods and that reports covering those periods can be prepared for the business. Most companies report results at least annually and perhaps at other intervals during the year. The going concern assumption states that the business will remain in operation for the foreseeable future.

*27. GAAP generally uses one of two measurement principles. The historical cost principle

states that assets are record at their cost. Cost is used because it is easy to verify: usually there is documentation when an asset is purchased. The fair value principle indicates that assets and liabilities should be reported at fair value (the price received to sell an asset or settle a liability).

*28. The full disclosure principle requires that companies must disclose all circumstances and

events that would make a difference to financial statement users. If a piece of information is not disclosed in one of the four financial statements, then it should be included in the notes to the statements.

29. The cost constraint relates to the fact that providing information is costly. In deciding what

information companies should provide, accounting standard-setters weigh the cost of providing that information against the benefits users will have from having that information available.


LECTURE OUTLINE

A. Timing Issues.

1. The assumption that the economic life of a business can be divided into artificial time periods.

2. Monthly and quarterly time periods are called interim periods.

3. An accounting time period that is one year in length is a fiscal year.

B. Accrual- vs. Cash-Basis Accounting.

1. Using the accrual basis to determine net income means companies rec-ognize revenues when they actually perform the services (rather than when they receive cash). It also means recognizing expenses when incurred (rather than when paid).

2. Under cash-basis accounting, companies record revenue when they receive cash. They record an expense when they pay out cash.

C. Recognizing Revenues and Expenses.

1. The revenue recognition principle requires that companies recognize reve-nue in the accounting period in which the performance obligation is satisfied.

2. The expense recognition principle requires that efforts (expenses) be matched with accomplishments (revenues). Expenses are matched with revenues in the period when efforts are expended to generate revenues.


ETHICS INSIGHT

Allegations of abuse of the revenue recognition principle have become all too common in recent years. One company was accused of saying that a sale that occurred at the beginning of one quarter occurred at the end of the previous quarter in order to achieve the previous quarters sales targets.

What motivates sales executives and finance and accounting executives to participate in activities that result in inaccurate reporting of revenues?

Answer: Sales executives typically receive bonuses based on their ability to meet quarterly sales targets. In addition, they often face the possibility of losing their jobs if they miss those targets. Executives in accounting and finance are very aware of the earnings targets of Wall Street analysis and investors. If they fail to meet these targets, the company’s stock price will fall. As a result of these pressures, executives sometimes knowingly engage in unethical efforts to misstate revenues. As a result of the Sarbanes-Oxley Act, the penalties for such behavior are now much more severe.

D. The Basics of Adjusting Entries.

1. In order for revenues and expenses to be reported in the correct period, companies make adjusting entries at the end of the accounting period. Adjusting entries ensure that revenues are recognized in the period in which services are performed, and that expenses are recognized in the period in which they are incurred.

2. A company must make adjusting entries every time it prepares financial statements.

3. Deferrals (prepaid expenses and unearned revenues).

a. Expenses paid in cash before they are used or consumed; they expire either with the passage of time or through use (supplies, insurance, rent).


b. Depreciation Adjustment.

(1) Depreciation is the process of allocating the cost of an asset to expense over its useful life in a rational and systematic manner.

(2) Depreciation expense is computed by dividing the cost of an asset by its useful life.

(3) Accumulated depreciation is a contra-asset account that is offset against an asset account on the balance sheet.

c. When companies receive cash before services are performed, they record a liability called unearned revenues (magazine subscriptions, customer deposits).

ACCOUNTING ACROSS THE ORGANIZATION

Gift cards are popular with marketing executives, but they create accounting questions. Should revenue be recorded at the time the gift card is sold, or when it is used by the customer?

Suppose a customer purchases a $100 gift card at Best Buy on December 24, 2013, and gives it to his wife on December 25, 2013. On January 3, 2014, the customer’s wife uses the card to purchase CDs. When do you think Best Buy should recognize revenue, and why?

Answer: According to the revenue recognition principle, companies should recognize revenue when the performance obligation is satisfied. In this case revenue is not recognized until Best Buy provides the goods. Thus, when Best Buy receives cash in exchange for the gift card on December 24, 2013 it should recognize a liability, Unearned Revenue, for $100. On January 3, 2014 when the customer’s wife exchanges the card for merchandise, Best Buy should recognize revenue and eliminate $100 from the balance in the Unearned Revenue account.


4. Accruals (accrued revenues and accrued expenses).

a. Revenues for services performed but not yet recorded at the statement date are accrued revenues (interest, rent, commissions).

b. Expenses incurred but not yet paid or recorded at the statement date are accrued expenses (interest, salaries, taxes).

5. Adjusting entries are recorded in the general journal and follow the last transaction entry. They are posted to the ledger accounts at the end of the accounting period.

E. The Adjusted Trial Balance and Financial Statements.

1. The adjusted trial balance is prepared after all adjusting entries have been journalized and posted.

2. The adjusted trial balance proves the equality of the total debit balances and the total credit balances in the ledger after all adjustments.

3. Companies can prepare financial statements directly from the adjusted trial balance. Companies first prepare the income statement from the revenue and expense accounts. Companies then prepare the balance sheet from the asset and liability accounts and the ending owner’s capital balance as reported in the owner’s equity statement.

*F. Alternative Treatment of Prepaid Expenses and Unearned Revenue.

1. Companies may initially debit prepaid expenses to an expense account instead of an asset account. The adjusting entry requires recording an asset for the unexpired portion and crediting the expense account so that its balance will reflect the amount consumed.


2. Companies may initially credit revenues received in cash before being recognized to a revenue account instead of a liability account. The adjusting entry requires recording a liability for the portion still to be recognized and debiting the revenue account so that its balance will reflect the amount recognized.

*G. Discuss Financial Reporting Concepts.

1. To be useful, information should possess two fundamental qualities: relevance and faithful representation.

a. Relevance – if information has the ability to make a difference in a decision scenario, it is relevant.

b. Accounting information is considered relevant if it provides information that has predictive value – helps provide accurate expectations about the future, and has confirmatory value – confirms or corrects prior expectations.

c. Materiality is a company-specific aspect of relevance. An item is material when its size makes it likely to influence the decision of an investor or creditor.

d. Faithful Representation – information accurately depicts what really happened. To provide a faithful representation, information must be:

(1) complete—nothing important has been omitted,

(2) neutral—is not biased toward one position or another, and

(3) free from error.


2. Enhancing Qualities – include comparability, consistency, verifiability, timeliness, and understandability.

a. Comparability—when different companies use the same accounting principles.

(1) To make a comparison, companies must disclose the accounting methods used.

b. Consistency—when a company uses the same accounting principles and methods from year to year.

c. Verifiable—quality of information that occurs when independent measures obtain similar results.

d. Timely—information that is available to decision makers before it loses its capacity to influence decisions.

e. Understandability—information presented in a clear fashion so that users can interpret it and comprehend its meaning.

3. Monetary Unit Assumption – states that only transactions expressed in money are included in the accounting records.

4. Economic Entity Assumption

Every economic entity can be separately identified and accounted for.

Economic events can be identified with a particular unit of accountability.

5. Time Period (Periodicity) Assumption – allows the business to be divided into artificial time periods that are useful for reporting.

6. Going Concern Assumption – Assumes the business will remain in operation for the foreseeable future.

7. Measurement Principles – GAAP generally uses one of two measurement principles: the historical cost principle or the fair value principle.


a. Historical Cost Principle – requires assets to be recorded at original cost because that amount is verifiable.

b. Fair Value Principle – requires that assets and liabilities should be reported at fair value (the price received to sell an asset or settle a liability).

8. Full Disclosure Principle – requires that all circumstances and events that would make a difference to financial statement users should be disclosed.

9. Cost Constraint – determining whether the cost that companies will incur to provide the information will outweigh the benefit that financial statement users will gain from having the information available.


IFRS A Look at IFRS It is often difficult for companies to determine in what time period they should report particular revenues and expenses. Both the IASB and FASB are working on a joint project to develop a common conceptual framework, as well as a revenue recognition project, that will enable companies to better use the same principles to record transactions consistently over time. KEY POINTS

In this chapter, you learned accrual-basis accounting applied under GAAP. Companies applying IFRS also use accrual-basis accounting to ensure that they record transactions that change a company’s financial statements in the period in which events occur.

Similar to GAAP, cash-basis accounting is not in accordance with IFRS. IFRS also divides the economic life of companies into artificial time periods.

Under both GAAP and IFRS, this is referred to as the time period assumption.

IFRS requires that companies present a complete set of financial statements, including comparative information annually.

The general revenue recognition principles required by GAAP that are used in this textbook are similar to those under IFRS.

Revenue recognition fraud is a major issue in U.S. financial reporting. The same situation occurs in other countries, as evidenced by revenue recognition breakdowns at Dutch software company Baan NV, Japanese electronics giant NEC, and Dutch grocer Ahold NV.

Under IFRS, revaluation of items such as land and buildings is permitted. IFRS allows depreciation based on revaluation of assets, which is not permitted under GAAP.

The terminology used for revenues and gains, and expenses and losses, differs somewhat between IFRS and GAAP. For example, income under IFRS is defined as:

Increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from shareholders.


Income includes both revenues, which arise during the normal course of operating activities, and gains, which arise from activities outside of the normal sales of goods and services. The term income is not used this way under GAAP. Instead, under GAAP income refers to the net difference between revenues and expenses. Expenses under IFRS are defined as:

Decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity other than those relating to distributions to shareholders.

Note that under IFRS, expenses include both those costs incurred in the normal course of operations, as well as losses that are not part of normal operations. This in contrast to GAAP, which defines each separately.

LOOKING TO THE FUTURE The IASB and FASB have recently completed a joint project on revenue recognition. The purpose of this project was to develop comprehensive guidance on when to recognize revenue. Presently, the Boards are considering an approach that focuses on changes in assets and liabilities as the basis for revenue recognition. It is hoped that this approach will lead to more consistent accounting in this area.


20 MINUTE QUIZ

Circle the correct answer. True/False

1. Since companies find it desirable and necessary to report the results of their activities frequently, the time period assumption assumes that the economic life of a business can be divided into artificial time periods.

True False

2. The revenue recognition principle requires that companies recognize revenue in the period in which cash was received rather than when the performance obligation is satisfied.

True False

3. Monthly and quarterly time periods are commonly referred to as fiscal periods.

True False

4. Payments of expenses that will benefit more than one accounting period are referred to as prepaid expenses.

True False

5. Cost less accumulated depreciation is a measurement of the current value of an asset such as equipment or a building.

True False

6. Depreciation is the process of allocating the cost of an asset to expense over its useful life in a rational and systematic manner.

True False

7. The adjusting entry for unearned revenues results in a debit to an asset account and a credit to a revenue account.

True False

8. A contra-asset account is an account whose balance is deducted from a related asset in the financial statements.

True False

9. When accrual-basis accounting is applied, adjusting entries are not necessary.

True False


10. Adjustments for accrued expenses are necessary to record the obligations that exist at the balance sheet date and to recognize the expenses that are applicable to the current accounting period.

True False

Multiple Choice

1. The recording of salaries and wages earned but not yet paid is an example of an adjustment that a . recognizes an accrued expense. b. recognizes an unrecorded revenue. c . apportions revenues between two or more periods. d. apportions costs between two or more periods.

2. A list of the accounts and their balances after all adjustments have been made is known as a . adjusting entries. b. adjusted trial balance. c . book values. d. accrued accounts.

3. Prior to recording adjusting entries, revenues exceed expenses by $60,000. Adjusting entries for accrued salaries and wages of $10,000 and depreciation expense of $10,000 were made. Net income for the year would be a . $60,000. b. $50,000. c . $40,000. d. none of the above.

4. The adjustment for depreciation is an example of a . recognizing an accrued expense. b. apportioning costs between two or more periods. c . apportioning revenues between two or more periods. d. recognizing an unrecorded revenue.

5. Most businesses choose fiscal years which correspond to a . the calendar year. b. any twelve-month period. c . their natural business year. d. any of the above.


ANSWERS TO QUIZ

True/False

1. True 2. False 3. False 4. True 5. False 6. True 7. False 8. True 9. False 10. True

Multiple Choice

1. a . 2. b. 3. c . 4. b. 5. d.

chapter 3 adjusting the accounts · copyright © 2013 john wiley & sons, inc. weygandt,...

Documents