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CHAPTER 4

Income Measurement and Ac-crual Accounting

OVERVIEW OF EXERCISES, PROBLEMS, AND CASESEstimated

Time inLearning Objective Exercises Minutes Level

1. Explain the significance of recognition and measurement 18* 20 Diffin the preparation and use of financial statements.

2. Explain the differences between the cash and accrual 18* 20 Diffbases of accounting.

3. Describe the revenue recognition principle and explain its 1 10 Easyapplication in various situations. 18* 20 Diff

4. Describe the matching principle and the various methods 2 10 Modfor recognizing expenses. 19* 15 Mod

20* 15 Mod

5. Identify the four major types of adjustments and determine 3 10 Easytheir effect on the accounting equation. 4 10 Easy

5 20 Easy6 20 Easy7 15 Easy8 15 Easy9 15 Easy

10 15 Mod11 15 Easy12 15 Easy13 15 Easy14 15 Easy15 10 Mod16 15 Mod19* 15 Mod20* 15 Mod

6. Explain the steps in the accounting cycle and the significance 17 5 Easyof each step.

*Exercise, problem, or case covers two or more learning objectivesLevel = Difficulty levels: Easy; Moderate (Mod); Difficult (Diff)

4-1

4-2 FINANCIAL ACCOUNTING SOLUTIONS MANUAL

Problems Estimatedand Time in

Learning Objective Alternates Minutes Level

1. Explain the significance of recognition and measurement in the preparation and use of financial statements.

2. Explain the differences between the cash and accrual 8* 25 Modbases of accounting.

3. Describe the revenue recognition principle and explain its application in various situations. 8* 25 Mod

9* 25 Diff

4. Describe the matching principle and the various methods 8* 25 Modfor recognizing expenses. 9* 25 Diff

5. Identify the four major types of adjustments and determine 1 20 Modtheir effect on the accounting equation. 2 20 Mod

3 20 Mod4 15 Mod5 20 Mod6 25 Mod7 15 Mod

10* 60 Mod

6. Explain the steps in the accounting cycle and the significance 10* 90 Modof each step.

*Exercise, problem, or case covers two or more learning objectives# Original problem only**Alternate problem onlyLevel = Difficulty levels: Easy; Moderate (Mod); Difficult (Diff)

CHAPTER 4 INCOME MEASUREMENT AND ACCRUAL ACCOUNTING 4-3

EstimatedTime in

Learning Objective Cases Minutes Level

1. Explain the significance of recognition and measurement in the preparation and use of financial statements. 1* 30 Mod

2. Explain the differences between the cash and accrual 1* 30 Mod bases of accounting. 3* 30 Mod

5* 60 Diff

3. Describe the revenue recognition principle and explain its 1* 30 Modapplication in various situations. 2 30 Mod

3* 30 Mod5* 60 Diff

4. Describe the matching principle and the various methodsfor recognizing expenses. 3* 30 Mod

4 25 Mod5* 60 Diff6 45 Mod

5. Identify the four major types of adjustments and determine 5* 60 Difftheir effect on the accounting equation.

6. Explain the steps in the accounting cycle and the significance of each step.

*Exercise, problem, or case covers two or more learning objectivesLevel = Difficulty levels: Easy; Moderate (Mod); Difficult (Diff)


Q U E S T I O N S

1. The accountant cannot show a stockholder or other user the company’s assets, such as cash and buildings. Instead, what the user sees is a representation or de-piction of the real thing. The accountant describes with words and numbers the various items in the financial statements.

2. Accountants strive to present financial statements that are both relevant to the decisions made by users of the statements and also reliable or verifiable. Some-times, however, there are trade-offs. For example, in deciding whether an asset that a company pledges as collateral for a loan is sufficient, a banker may be most interested in the current value of the asset. That is, this amount may be the most relevant attribute or characteristic of the asset for the banker’s needs. The accountant, however, may be reluctant to present the current value of the asset on the balance sheet because of the difficulty in measuring the value of the asset with any degree of reliability. The amount paid for the asset—that is, its historical cost—may be more reliable, although not as relevant to the banker’s decision.

3. The realtor will recognize revenue from the sale of the home on July 8 if the cash basis is used because this is the date cash is received. Revenue will be recog-nized on June 12 if the accrual basis is used because this is the date the sale takes place and thus is the date on which the revenue is earned.

4. This statement is not entirely accurate. Because it is based on historical cash flows, a statement of cash flows is not necessarily the most accurate source of in-formation on the future cash flow prospects for a company. An income statement may in fact provide more important information about future cash flows. For ex-ample, an income statement includes not only sales on a cash basis this period but also sales on credit that will generate cash flows in future periods. Similarly, a statement of cash flows reports only expenses that required a cash outlay in the current period. An accrual-based income statement provides information on ac-crued expenses that will result in a cash outlay in future periods.

5. The time period assumption is important in accounting because financial state-ment users want information about a company as of a particular point in time and for distinct periods of time. For example, a potential stockholder wants to know the financial position at the end of the most recent year and the profit of a busi-ness for the most recent year. Under an accrual accounting system, revenues are recognized when they are earned regardless of when cash is received, and ex-penses are recognized when they are incurred regardless of when cash is paid. The accountant does not wait until all of the cash from a sale has been collected to report the sale on the income statement. In this way, the user of the statement receives information on a timely basis.


6. No, the recognition of revenue is not always the result of the acquisition of an as-set. Assume that a publisher sells a magazine subscription and collects cash from the customer in advance. At the time cash is collected, the publisher incurs a lia-bility. As each month’s magazine is mailed to the customer, a portion of the liabil-ity is satisfied and revenue is recognized. Thus, in some instances, revenue re-sults from the settlement of a liability.

7. A company incurs a cost when it acquires an asset. For example, assume that a retailer buys a product for $100 on October 21. On this date, it has incurred a cost of $100 to acquire an asset, namely merchandise inventory. The asset will be removed from the records and an expense recognized, namely cost of goods sold, when the product is sold. In place of the inventory, the company will acquire another asset, either cash or an account receivable. In summary, assets are un-expired costs and expenses are expired costs.

8. Depreciation is the process of allocating the cost of a tangible long-term asset to its useful life. For example, the accountant attempts to recognize or match the cost of a machine as an expense over the period of time that the machine is used to manufacture products.

9. The four basic types of adjustments are:

a. To recognize the expired portion of a prepaid expense. For example, an ad-justment is needed at the end of each month to recognize insurance expense for the portion of an insurance policy that has expired during the period.

b. To recognize the earned portion of a deferred revenue or liability. For exam-ple, a publisher has to make an adjustment at the end of each period to recog-nize the earned portion of a subscription.

c. To recognize expense at the end of the period before cash is paid. For exam-ple, an adjustment is made at the end of the year to recognize income tax ex-pense, even though the taxes will not be paid until early in the following year.

d. To recognize revenue at the end of the period before cash is received. For ex-ample, a landlord will need to make an adjustment at the end of the month for the rent owed by a tenant but not payable until some time during the following month.


10. Balance sheet accounts are called real accounts because they are permanent and are not closed at the end of a period. Conversely, income statement ac-counts are called nominal accounts because they are temporary and are closed at the end of the period. For example, it would not make sense to close the Equipment account at the end of the period. The account should stay on the books as long as the company keeps the asset. On the other hand, Depreciation Expense on the equipment is a temporary account that indicates the expense as-sociated with using the asset during the period and is therefore closed along with all other income statement accounts at the end of the period.

11. Closing entries serve two important purposes. First, the balances in all temporary or nominal accounts are returned to zero to start the next accounting period. Sec-ond, the net income and the dividends of the period are transferred to the Re-tained Earnings account.

E X E R C I S E S

LO 3 EXERCISE 4-1 REVENUE RECOGNITION

Cash collected at toll booth $ 3,000,000Passes redeemed 1,700,000

Revenue recognized $ 4,700,000

Only the amount of passes that have been used should be recognized as rev-enue. The difference between the $2,000,000 of passes issued and the $1,700,000 of passes used is unearned revenue at this point.

LO 4 EXERCISE 4-2 THE MATCHING PRINCIPLE

1. b

2. c

3. b or c (would recognize immediately if supplies are normally used up within the period)

4. c

5. a

6. c

7. a

8. c

9. bLO 5 EXERCISE 4-3 ACCRUALS AND DEFERRALS


1. AL 5. DE

2. DR 6. DR

3. AA 7. AL

4. DE 8. AA

LO 5 EXERCISE 4-4 OFFICE SUPPLIES

To record office supplies used.

BALANCE SHEET INCOME STATEMENT

Assets = Liabilities + Stockholders’ Equity+ Revenues – Expenses

5/31 Office Supplies Office Supplieson Hand (1,630) Expense (1,630)

(1,450 + 1,100 – 920)

Net income for the month of May would be overstated by $1,630 if this adjustment were not recognized, because expenses would be understated.

LO 5 EXERCISE 4-5 PREPAID RENT—QUARTERLY AD-JUSTMENTS

1. $12,000/6 months = $2,000 per month.

2. To record prepayment of six months’ rent on September 1.



9/1 Prepaid Rent 12,000

Cash (12,000)

3. To record one month of rent expense on September 30.



9/30 Prepaid Rent Expense (2,000) Rent (2,000)

4. If the accountant forgot to record an adjustment on December 31, net income for the year would be overstated by $6,000 ($2,000 per month 3 months).

LO 5 EXERCISE 4-6 DEPRECIATION


1. To record purchase of combine on July 1.



7/1 Equipment 100,000Cash (100,000)

2. Purchase price $ 100,000Less: Estimated salvage value (16,000 )Depreciable cost $ 84,000

3. Monthly depreciation = depreciable cost/estimated life = $84,000/84 months = $1,000/month.

4. To record one month’s depreciation expense on July 31.



7/31 Accumulated Depreciation Depreciation (1,000) Expense (1,000)

5. Equipment $ 100,000Less: Accumulated depreciation (6 months ×

$1,000/month) (6,000 )Carrying value $ 94,000

LO 5 EXERCISE 4-7 PREPAID INSURANCE—ANNUAL ADJUST-MENTS

1. Monthly cost: $72,000/24 months = $3,000.

2. To record purchase of 24-month policy on April 1.



4/1 Prepaid Insurance 72,000 Cash (72,000)


EXERCISE 4-7 (Concluded)

3. To record expiration of nine months of insurance on December 31.



12/31 Prepaid Insurance Insurance (27,000) Expense

(27,000)

4. Net income will be overstated by $27,000 if the accountant forgets to record an ad-justment to recognize an expense.

LO 5 EXERCISE 4-8 SUBSCRIPTIONS

1. To record collection of 900 subscriptions of $30 each in August.



Aug. Cash 27,000 Subscriptions Received in Advance 27,000 (900 30)

2. To record subscriptions earned during August and recorded on August 31.



8/31 Subscriptions Subscriptions Received in Revenue 7,500 Advance (7,500) (40,500 + 27,000 – 60,000)

3. Net income for the month would be understated by $7,500 if the accountant forgot to make the adjustment to recognize revenue earned.


LO 5 EXERCISE 4-9 CUSTOMER DEPOSITS

1. To record on April 1 receipt of customer deposit for three months of legal service.



4/1 Cash 9,000 Customer Deposits 9,000

2. To record on April 30 one month of legal fees earned.



4/30 Customer Legal Fees Deposits (3,000) Earned 3,000

(9,000/3)

3. If the April 30 adjustment is not recorded, net income will be understated by $3,000.

LO 5 EXERCISE 4-10 WAGES PAYABLE

1. Weekly payroll: $10 per hour 7 hours per day 5 days 50 employees = $17,500

2. To record payment of weekly payroll on October 27.



10/27 Cash (17,500) Wages Expense (17,500)

3. To record accrual for two days’ wages on October 31.



10/31 Wages Payable 7,000 Wages Expense (7,000)(17,500/5 days × 2 days)

4. To record payment of weekly payroll on November 3.



11/3 Cash (17,500) Wages Payable (7,000) Wages Expense (10,500)


5. Net income for October would be overstated by $7,000 if the company failed to record accrued wages on October 31.

LO 5 EXERCISE 4-11 INTEREST PAYABLE

1. To record 12%, 90-day loan from First National Bank on March 1.



3/1 Cash 100,000 Note Payable 100,000

2. To accrue interest due on note for one month on March 31.



3/31 Interest Payable 1,000 Interest Expense (1,000)(100,000 .12 30/360)

To accrue interest due on note for one month on April 30.



4/30 Interest Payable 1,000 Interest Expense (1,000)

3. To record payment of note and interest at maturity date on May 30.



5/30 Cash (103,000) Note Payable (100,000) Interest Expense (1,000)Interest

Payable (2,000)

LO 5 EXERCISE 4-12 PROPERTY TAXES PAYABLE—AN-NUAL ADJUSTMENTS

1. To accrue 2007 property taxes on December 31.



200712/31 Property Taxes Property Tax

Payable 52,500 Expense (52,500)(50,000 1.05)


EXERCISE 4-12 (Concluded)

2. To record payment of 2007 property taxes on June 1.



20086/1 Cash (52,500) Property Taxes

Payable (52,500)

LO 5 EXERCISE 4-13 INTEREST RECEIVABLE

1. To record 10%, 60-day loan to MaxiDriver Inc. on June 1.



6/1 Cash (60,000)Note

Receivable 60,000

2. To accrue interest due on note for one month on June 30.



6/30 Interest Interest Receivable 500 Income 500

(60,000 .10 30/360)

3. To record collection of note and interest at maturity date on July 31.



7/31 Cash 61,000 Interest Income 500Note Receivable (60,000)Interest Receivable (500)


LO 5 EXERCISE 4-14 UNBILLED ACCOUNTS RECEIVABLE

1. Under the revenue recognition principle, revenue should be recorded when ser-vices are performed, because this is the point at which revenue is earned.

2. To record on June 30 unbilled service fees earned during June.



6/30 Accounts Service Fees Receivable 40,000 Earned 40,000

LO 5 EXERCISE 4-15 THE EFFECT OF IGNORING ADJUSTMENTS ON NET INCOME

1. O 4. O

2. U 5. O

3. O 6. U

LO 5 EXERCISE 4-16 THE EFFECT OF ADJUSTMENTS ON THE AC-COUNTING EQUATION

Assets = Liabilities + Stockholders’ Equity1. D NE D2. NE I D3. D NE D4. NE D I5. I NE I6. NE I D

LO 6 EXERCISE 4-17 THE ACCOUNTING CYCLE

Order in the accounting cycle: 4, 7, 1, 5, 3, 6, 2


MULTI-CONCEPT EXERCISES

LO 1,2,3 EXERCISE 4-18 REVENUE RECOGNITION, CASH AND ACCRUAL BASIS

1. Accrual-basis income statements:

HATHAWAY HEALTH CLUBINCOME STATEMENTS

FOR THE YEARS ENDED DECEMBER 31

Year 1 Year 2 Year 3Sales*$ 122,000 $152,000 $ 182,000 Expenses:

Depreciation** $ 33,000 $ 33,000 $ 33,000Salaries and wages 50,000 50,000 50,000Advertising 5,000 5,000 5,000Rent and utilities 36,000 36,000 36,000

Total expenses $ 124,000 $ 124,000 $ 124,000 Net income (loss) $ (2,000 ) $ 28,000 $ 58,000

*Year 1: $366,000/3 = $122,000 with a three-year membership; only one-third of the total recognized.

Year 2: $122,000 + [(100)($900)/3] (additional three-year memberships sold in second year, but only one-third recognized as revenue) = $152,000.

Year 3: $122,000 + $30,000 (additional year of revenue recognized on member-ships sold in year 2) + $30,000 (additional three-year memberships sold in third year, but only one-third recognized as revenue) = $182,000.

**($100,000 – $1,000)/3 years = $33,000 per year.

2. Under the revenue recognition principle, revenue is recognized not when cash is received but rather when revenue is earned. It is earned with the passage of time as members use the facilities over their respective three-year membership periods. Accrual-basis income statements allow the reader to focus on the long-term prof-itability of the business rather than simply on the amount of cash received in any given year.


LO 4,5 EXERCISE 4-19 DEPRECIATION EXPENSE

1. Depreciation expense for 2007:Truck [($18,000 – $3,000)/5] 9/12 = $2,250Computer [($55,000 – $5,000)/10] 6/12 = $2,500Building [($250,000 – $10,000)/30] 3/12 = $2,000

2. Certainly, it would be less costly in terms of the time spent by the accountant to ex-pense all costs rather than treat certain ones as assets to be written off over their useful lives. However, this is a violation of the matching principle which requires that costs be allocated to the periods during which they provide benefits, i.e., aid the generation of revenue. Estimates such as those required to depreciate assets are a normal and necessary part of an accrual accounting system.

LO 4,5 EXERCISE 4-20 ACCRUAL OF INTEREST ON A LOAN

1. To record two-month, 12% bank loan on July 1.



a. 7/1 Cash 50,000 Notes Payable 50,000

To accrue one-month interest on bank loan on July 31.



b. 7/31 Interest Payable 500 Interest Expense (500)(50,000 .12 1/12)

To record repayment of principal and interest on bank loan on August 31.



c. 8/31 Cash (51,000) Interest Payable (500) Interest Expense (500)Notes Payable (50,000)

2. It would save the time and cost in making a journal entry to skip an adjustment on July 31 and simply record interest when the loan is repaid on August 31. However, to do so would violate the matching principle. One of the necessary costs in July was interest, and it should be matched with the revenues of that period. If interest were not accrued at the end of July, the expense for that month would be under -stated and the expense for August would be overstated.


P R O B L E M S

LO 5 PROBLEM 4-1 ADJUSTMENTS

1. Adjustments on March 31, 2007:

To accrue interest.



a. 3/31 Interest Payable 100 Interest Expense (100)(15,000 .08 30/360)

To record supplies used.



b. 3/31 Office Supplies Supplies Expense (660) on Hand (660) (1,280 + 750 – 1,370)

To record depreciation.



c. 3/31 Accumulated Depreciation Depreciation— Expense (800) Office Equipment (800) (62,600 – 5,000) 1/72

To accrue wages.



d. 3/31 Wages Payable 5,700 Wages Expense (5,700)(950 6)

To recognize rent earned.



e. 3/31 Rent Collected Rent Revenue 2,500 in Advance (2,500)


PROBLEM 4-1 (Concluded)

To record customer deposits earned.



f. 3/31 Customer Service Revenue 1,200 Deposits (1,200) (4,800/4)

To record estimated income taxes.



g. 3/31 Income Tax Income Tax Payable 3,900 Expense (3,900)

2. Income before adjustments $ 23,000Rent revenue + 2,500Service revenue + 1,200Interest expense (100)Supplies expense (660)Depreciation expense (800)Wages expense (5,700)Income tax expense (3,900 )Adjusted net income $ 15,540

LO 5 PROBLEM 4-2 ANNUAL ADJUSTMENTS

1. Adjustments on December 31, 2007:

To record annual depreciation expense.



a. 12/31 Accumulated Depreciation Depreciation (2,950) Expense (2,950) (15,000 – 250)/5 years

To record supplies used during the year.



b. 12/31 Supplies Supplies on Hand (19,350) Expense (19,350) (3,600 + 17,600 – 1,850)



To record customer deposits earned between August and December.



c. 12/31 Customer Fees Earned 20,000Deposits (20,000)(24,000/6 months) × 5 months

To record rent expense for November through December.



d. 12/31 Prepaid Rent (5,400) Rent Expense (5,400) (2,700 × 2)

To accrue interest payable on note.



e. 12/31 Interest Payable 3,000 Interest Expense (3,000)(200,000 × .09 × 60/360)

To accrue wages payable at year-end.



f. 12/31 Wages Payable 500 Wage Expense (500)

2. Net increase (decrease) in net income from adjustments:a. Depreciation expense $ (2,950)b. Supplies expense (19,350)c. Fees earned 20,000d. Rent expense (5,400)e. Interest expense (3,000)f. Wage expense (500 )Overstatement of 2007 net income $ (11,200 )


LO 5 PROBLEM 4-3 RECURRING TRANSACTIONS AND ADJUST-MENTS

a. 1, 12, 13 i. 8, 1b. 5, 1 j. 17, 9c. 7, 1, 11 k. 15, 4d. 3, 1 l. 16, 3e. 4, 8 m. 11, 19, 1f. 1, 14 n. 18, 6g. 1, 2 o. 20, 10h. 2, 14

LO 5 PROBLEM 4-4 USE OF ACCOUNT BALANCES AS A BASIS FOR ANNUAL ADJUSTMENTS


To recognize expired insurance.



a. 12/31 Prepaid Insurance Insurance (1,000) Expense (1,000)

(7,200 5/36)

To recognize rent earned.



b. 12/31 Rent Collected in Rent Revenue 3,500 Advance (3,500) (6,000 7/12)

To recognize interest earned.



c. 12/31 Interest Interest Revenue 1,500 Receivable 1,500

(50,000 .09 4/12)

2. If adjustments were made at the end of each month, the Prepaid Insurance account would have been reduced by the monthly expense of $200 ($7,200/36) on four oc-casions: August 31, September 30, October 31, and November 30. Thus, the bal-ance in the account before the December adjustment would be $7,200 – [(4)($200)] = $6,400.


LO 5 PROBLEM 4-5 USE OF ACCOUNT BALANCES AS A BASIS FOR ADJUSTMENTS

1. Adjustments on April 30, 2007:

To recognize one month’s insurance expense.



a. Prepaid Insurance (50) Insurance Expense (50)

To record supplies used.



b. Office Supplies (70) Office Supplies (250 – 180) Expense (70)




c. Accumulated Depreciation Depreciation— Expense (417) Office Equip-

ment (417) (50,000 1/120)




d. Accumulated Depreciation Depreciation— Expense (200) Automobile (200) (12,000 1/60)



To record commissions earned.



e. Unearned Commissions Commissions (4,500) Earned 4,500(9,500 – 5,000)

To record revenue earned, not yet collected.



f. Accounts Commissions Receivable 1,500 Earned 1,500

To record interest on note payable.



g. Interest Payable 20 Interest Expense (20)

To record salaries not yet paid.



h. Salaries Payable 2,500 Salaries Expense (2,500)

2. Net increase (decrease) in net income from adjustments:Insurance expense $ (50)Office supplies expense (70)Depreciation expense (417)Depreciation expense (200)Commissions earned 4,500Commissions earned 1,500Interest expense (20)Salaries expense (2,500 )Net increase in net income $ 2,743

3. The office equipment was purchased on April 1, 2006, and has been depreciated for one year before depreciation is recorded for the month of April 2007. Thus, if the equipment has a 10-year life, the balance in Accumulated Depreciation will be $50,000/10 years, or $5,000.


LO 5 PROBLEM 4-6 RECONSTRUCTION OF ADJUSTMENTS FROM ACCOUNT BALANCES

1. To record insurance expense on June 30.



6/30 Prepaid Insurance (150) Insurance Expense (150) (3,600 – 3,450)

2. Cost of policy was $150 36 months = $5,400.

3. To record depreciation expense on June 30.



6/30 Accumulated Depreciation (Depreciation (80) Expense (80) (1,360 – 1,280)

4. Estimated useful life in months: $9,600/$80 month = 120 months.

5. To record interest expense on June 30.



6/30 Interest Payable 144 Interest Expense (144) (2,448 – 2,304)

6. Interest rate: ($144 per month 12 months)/$9,600 = 18%.

The monthly rate is 18%/12 months = 1.5%.

LO 5 PROBLEM 4-7 USE OF ACCOUNT BALANCES AS A BASIS FOR ADJUSTMENTS

1. Recording adjustments:

To record rent expense.



a. Prepaid Rent (600) Rent Expense (600)

PROBLEM 4-7 (Continued)


To record expense of worn-out videos.



b. Video Inventory (2,460) Video Expense (2,460)

To record depreciation expense on display stands.



c. Accumulated Depreciation Depreciation (140) Expense (140)

To record unpaid wages and salaries.



d. Wages and Wages and Salaries Salary Payable 1,450 Expense (1,450)

To record subscription revenue earned.



e. Customer Subscription Subscriptions (2,440) Revenue 2,440

To record accrued income taxes.



f. Income Taxes Income Tax Payable 849 Expense (849)

Explanations:

(a) $7,200/12 months

(b) $25,600 – $23,140

(c) ($8,900 – $500)/60 months



(f) Calculation of taxes due:Subscription revenue $ 2,440Rental revenue 9,200Wage and salary expense ($2,320 + $1,450) (3,770)Utility expense (1,240)Advertising expense (600)Rent expense (600)Video expense (2,460)Depreciation expense (140 )Income before tax $ 2,830 tax rate 0.30 Income tax expense $ 849

2. On the basis of the information available, Four Star appears to be a profitable busi-ness. Subscription revenue and rental revenue together total $11,640 for the month. Net income for the month is $2,830 – $849 (taxes), or $1,981. This results in a profit margin of $1,981/$11,640, or 17%.

M U L T I - C O N C E P T P R O B L E M S

LO 2,3,4 PROBLEM 4-8 CASH AND ACCRUAL INCOME STATEMENTS FOR A MANUFACTURER

1. Cash revenue: 500,000 components $2 $ 1,000,000Less: Amounts not yet received 150,000 Cash revenue $ 850,000 Accrual revenue: 500,000 components $2 $ 1,000,000

2. Under the matching principle, Drysdale should match all expenses to revenues generated. Thus, all expenses should be recognized during the year, except for the cost of the truck. The cost of $10,000 should be spread over the estimated useful life of five years.



3. Income statement under the accrual basis:

DRYSDALE COMPANYINCOME STATEMENT

FOR THE YEAR ENDED XX/XX/XX

Sales revenue $ 1,000,000Cost of goods sold 602,000 *

Gross profit $ 398,000 Operating expenses:

Sales and administrative salaries $ 100,000Truck depreciation 2,000 **

Total operating expenses $ 102,000 Net income $ 296,000

*Rent: $1,000 12 $ 12,000Raw materials 400,000Salaries and wages 190,000 Cost of goods sold $ 602,000

**$10,000/5 years

LO 3,4 PROBLEM 4-9 REVENUE AND EXPENSE RECOGNITION

Income statements for Years 1 and 2:

DARBY DELIVERY SERVICEINCOME STATEMENTS

Year 1 Year 2Sales revenue (a) $ 23,000 $ 46,000 Expenses:

Advertising (b) $ 2,000 $ 1,500Salaries (c) 15,000 24,000Rent (d) 5,000 5,000

Total expenses $ 22,000 $ 30,500 Net income $ 1,000 $ 15,500



Explanations:

a. Let X = Year 1 sales

Year 1 sales + 2(Year 1 sales) = $69,000

3X = $69,000;

X = $23,000 = Year 1 sales

2X = $46,000 = Year 2 sales

b. Total advertising expense $3,500

Less promotional portion 500

Total weekly expense $ 3,000 or $1,500/year

Year 1 advertising = $500 + $1,500 = $2,000

Year 2 advertising = $1,500

c. Let X = one employee's annual salary

1st year = X + 0.25X

2nd year = 2X

X + 0.25X + 2X = $39,000

3.25X = $39,000; X = $12,000

1st year = $12,000 + 0.25($12,000) = $15,000

2nd year = 2($12,000) = $24,000

d. Same rent for two years: $10,000/2 = $5,000

LO 5,6 PROBLEM 4-10 MONTHLY TRANSACTIONS, ADJUST-MENTS, AND FINANCIAL STATEMENTS

1. Effects on the accounting equation:

To record issuance of stock to owners on January 2.



1/2 Cash 60,000 Capital (3 20,000) Stock 60,000



To record purchase of a Victorian inn on January 2.



1/2 Land 15,000 House 35,000 Cash (50,000)

To record issuance of two-year, 12% promissory note on January 3.



1/3 Cash 30,000 Notes Payable 30,000

To record purchase of furniture for cash on January 4.



1/4 Furniture 15,000 Cash (15,000)

To record purchase of 24-month insurance policy on January 5.



1/5 Prepaid Insurance 6,000

Cash (6,000)

To record payment for advertising on January 6.



1/6 Cash (450) Advertising Expense (450)

To record purchase of cleaning supplies on account on January 7.



1/7 Cleaning Accounts Payable 950 Supplies 950



To record payment of wages for first half of month on January 15.



1/15 Cash (4,230) Wages Expense (4,230)

To record guest's prepayment for two-week stay on January 16.



1/16 Cash 980 Rent Received in Advance 980

To record cash receipts from rentals for January on January 31.



1/31 Cash 8,300 Revenue from Rental of Rooms 8,300

To record cash receipts from restaurant for January on January 31.



1/31 Cash 6,600 Restaurant Revenue 6,600

To record payment of dividends for January on January 31.



1/31 Cash (600) Dividends (600)(3 × 200)



2. List of accounts and account balances:AssetsCash $ 29,600Land 15,000House 35,000Furniture 15,000Prepaid Insurance 6,000Cleaning Supplies 950

LiabilitiesAccounts Payable $ 950Notes Payable 30,000Rent Received in Advance 980

Owners’ EquityCapital Stock $ 60,000Advertising Expense 450Wages Expense 4,230Revenue from Rental of Rooms 8,300Restaurant Revenue 6,600Dividends 600

3. Adjustments:

To record depreciation expense on the house.



a. Accumulated Depreciation Depreciation— Expense (100) House (100)

To record depreciation expense on the furniture.



b. Accumulated Depreciation Depreciation— Expense— Furniture (125) Furniture (125)

To record interest on the note.



c. Interest Payable 300 Interest Expense (300)



To record expired insurance.



d. Prepaid Insurance (250) Insurance Expense (250)

To record earned portion of guest’s deposit.



e. Rent Received Revenue from in Advance (490) Rental of Rooms 490

To record wages earned by employees.



f. Wages Payable 5,120 Wages Expense (5,120)

To record use of cleaning supplies.



g. Cleaning Supplies (720) Supplies Expense (720)

To record utility expense.



h. Utilities Payable 740 Utilities Expense (740)

To record income tax expense.



i. Income Tax Income Tax Payable 1,007 Expense (1,007)



Explanations for adjusting entry amounts:

(a) ($35,000 – $5,000)/300 months = $100/month

(b) $15,000/120 months = $125/month

(c) $30,000 12% 1/12 = $300/month

(d) $6,000/24 months = $250/month

(e) $980/2 weeks = $490/week

(f) $5,120 for second half of month

(g) $950 – $230 = $720 used

(h) $740 due at end of month(i) Calculation of tax expense:

Revenue from rental of rooms $ 8,790Restaurant revenue 6,600Wages expense (9,350)Advertising expense (450)Depreciation on house (100)Depreciation on furniture (125)Interest expense (300)Insurance expense (250)Supplies expense (720)Utilities expense (740 )Income before tax $ 3,355 Tax rate 0.30 Income tax expense $ 1,007



4. Financial statements:

(a) MOONLIGHT BAY INNINCOME STATEMENT

FOR THE MONTH ENDED JANUARY 31, 2007

Revenues:From rental of rooms $ 8,790From restaurant 6,600 Total revenues $15,390

Expenses:Advertising $ 450Wages 9,350Depreciation—house 100Depreciation—furniture 125Interest 300Insurance 250Supplies 720Utilities 740Income taxes 1,007

Total expenses 13,042 Net income $ 2,348

(b) MOONLIGHT BAY INN

STATEMENT OF RETAINED EARNINGSFOR THE MONTH ENDED JANUARY 31, 2007

Beginning balance, January 1, 2007 $ 0Add: Net income 2,348Deduct: Cash dividends 600 Ending balance, January 31, 2007 $ 1,748



(c) MOONLIGHT BAY INNBALANCE SHEETJANUARY 31, 2007

AssetsCurrent assets:

Cash $ 29,600Cleaning supplies 230Prepaid insurance 5,750

Total current assets $ 35,580Property, plant, and equipment:

Land $ 15,000House $ 35,000

Less: Accumulated depreciation 100 34,900

Furniture $ 15,000Less: Accumulated

depreciation 125 14,875 Total property, plant, and

equipment 64,775 Total assets $ 100,355

LiabilitiesCurrent liabilities:

Accounts payable $ 950Interest payable 300Wages payable 5,120Income tax payable 1,007Rent received in advance 490Utilities payable 740

Total current liabilities $ 8,607Long-term debt:

Notes payable 30,000 Total liabilities $ 38,607

Stockholders’ EquityCapital stock $ 60,000Retained earnings 1,748

Total stockholders’ equity $ 61,748 Total liabilities and stockholders’

equity $ 100,355

5. The inn has shown the ability to make a profit. The profit margin is $2,348/$15,390, or approximately 15%. This is an indication that the inn has been able to generate revenues and control the necessary costs in the process. The balance sheet shows a very strong current position for the inn. The current ratio is $35,580/$8,607, or over 4 to 1. The inn has almost enough cash on hand at the present time to repay the loan. On the basis of the financial state -ments alone, it appears that the banker should be comfortable with the loan made.


A L T E R N A T E P R O B L E M S

LO 5 PROBLEM 4-1A ADJUSTMENTS

1. Adjustments on June 30, 2007:

a. To accrue interest: $10,000 4% 1/12.



6/30 Interest Receivable 33 Interest Revenue 33

b. To record supplies used: $475 + $5,600 – $507.



6/30 Office Supplies Supplies Expense (5,568) on Hand (5,568)

c. To record depreciation: ($170,000 – $2,000) 1/48.



6/30 Accumulated Depreciation Depreciation— Expense (3,500) Machinery (3,500)

d. To record rent expense: $4,650/3.



6/30 Prepaid Rent (1,550) Rent Expense (1,550)

e. To accrue wages: $7,000.



6/30 Wages Payable 6,000 Wages Expense (6,000)


PROBLEM 4-1A (Concluded)

f. To record estimated income taxes.



6/30 Income Taxes Income Tax Payable 2,900 Expense (2,900)

2. Income before adjustments $35,000Interest revenue 33Supplies expense (5,568) Depreciation expense (3,500)Rent expense (1,550)Wages expense (6,000)Income tax expense (2,900 )Adjusted net income $ 15,515

LO 5 PROBLEM 4-2A ANNUAL ADJUSTMENTS

1. Adjustments:

a. To record annual depreciation expense: ($25,000 – $4,000)/7 years.



12/31 Accumulated Depreciation Depreciation (3,000) Expense (3,000)

b. To record supplies used during year: $1,200 + $12,900 – $900.



12/31 Supplies Supplies on Hand (13,200) Expense (13,200)

c. To record customer deposits earned between July and December: ($8,800/8 months) 6 months.



12/31 Customer Fees Earned 6,600 Deposits (6,600)



d. To record rent expense for September through December: $4,000 4.




e. To accrue interest payable on note: $30,000 6% 60/360.



12/31 Interest Payable 300 Interest Expense (300)

f. To accrue wages payable at year-end: $4,150/5.



12/31 Wages Payable 830 Wage Expense (830)

2. Net increase (decrease) in net income from adjustments:a. Depreciation expense $ (3,000)b. Supplies expense (13,200)c. Fees earned 6,600d. Rent expense (16,000)e. Interest expense (300)f. Wage expense (830 )Overstatement of 2007 net income $ (26,730 )

LO 5 PROBLEM 4-3A RECURRING TRANSACTIONS AND ADJUSTMENTS

a. 1, 11, 12 i. 2, 13b. 5, 1 j. 17, 6c. 2, 1 k. 19, 9d. 4, 7 l. 14, 4e. 1, 3 m. 15, 3f. 1,18g. 16,1h. 5, 1,10


LO 5 PROBLEM 4-4A USE OF ACCOUNT BALANCES AS A BA-SIS FOR ANNUAL ADJUSTMENTS


a. To record supplies used: $5,790 – $1,520.



12/31 Supplies (4,270) Supplies Expense (4,270)

b. To recognize revenue earned: $1,800 8/12.



12/31 Unearned Service Revenue 1,200Revenue (1,200)

c. To record interest on note: $60,000 10% 4/12.



12/31 Interest Interest Expense (2,000)Payable 2,000

2. If adjustments were made at the end of each month, the Unearned Revenue ac-count would have been reduced by the monthly revenue of $150 ($1,800/12) at the end of each of seven months, beginning on May 31 and ending on November 30. Thus, the balance in the account before the December adjustment would be $1,800 – [(7)($150)] = $750.


LO 5 PROBLEM 4-5A USE OF ACCOUNT BALANCES AS A BA-SIS FOR ADJUSTMENTS

1. Adjustments on June 30, 2007:

a. To recognize one month's rent expense.



6/30 Prepaid Rent (600) Rent Expense (600)

b. To record supplies used: $15,210 – $1,290.



6/30 Office Supplies Supplies (13,920) Expense (13,920)

c. To record depreciation: ($46,120 – $6,120) 1/120.



6/30 Accumulated Depreciation Depreciation— Expense (333)Equipment (333)

d. To record interest on note payable.




e. To record salaries not yet paid.



6/30 Salaries Payable 620 Salaries Expense (620)



2. Net increase (decrease) in net income from adjustments:a. $ (600)b. (13,920)c. (333)d. (50)e. (620 )Net decrease in net income from adjustments $ (15,523 )

3. The office equipment was purchased on June 1, 2006, and has been depreciated for one year before depreciation is recorded for the month of June 2007. Thus, if the equipment has a 10-year life, the balance in Accumulated Depreciation will be ($46,120 – $6,120/10 years), or $4,000.

LO 5 PROBLEM 4-6A RECONSTRUCTION OF ADJUSTMENTS FROM ACCOUNT BALANCES

1. To record rent expense on June 30: $4,000 – $3,000.




2. At $1,000 per month, the original six-month payment and balance of Prepaid Rent on April 1, 2007, was $6,000.

3. To record depreciation expense on June 30: $900 – $800.



6/30 Accumulated Depreciation Depreciation (100) Expense (100)

4. Estimated useful life in months: $9,600/$100 month = 96 months.

5. To record interest expense on June 30: $864 – $768.




6. Interest rate: ($96 per month 12 months)/$9,600 = 12% (annual rate). The monthly rate is 12%/12 months = 1%.


LO 5 PROBLEM 4-7A USE OF ACCOUNT BALANCES AS A BASIS FOR ADJUSTMENTS

1. Adjustments:



a. Prepaid Rent (400) Rent Expense (400)



b. Accumulated Depreciation Depreciation (150) Expense (150)



c. Chemical Chemical Inventory (8,100) Expense (8,100)



d. Wages and Wages and Salaries Salary Payable 1,080 Expense (1,080)



e. Income Taxes Income Tax Payable 1,881 Expense (1,881)

Explanations:

(a) $4,800/12 months = $400/month

(b) ($18,200 – $200)/120 months = $150/month

(c) ($9,400 – $1,300) = $8,100



(e) Calculation of taxes due:Treatment revenue $ 40,600Wages and salary expense (23,580)Utility expense (1,240)Advertising expense (860)Rent expense (400)Depreciation expense (150)Chemical expense (8,100 )Income before tax $ 6,270 Tax rate 0.30 Income tax expense $ 1,881

2. On the basis of the information available, Lewis appears to be a profitable busi-ness. Net income for the month was $6,270 – $1,881 (taxes), or $4,389. With treat-ment revenue of $40,600, this results in a profit margin of $4,389/$40,600, or ap-proximately 11%.

A L T E R N A T E M U L T I - C O N C E P T P R O B L E M S

LO 2,3,4

PROBLEM 4-8A CASH AND ACCRUAL INCOME STATEMENTS FOR A MANUFACTURER

1. Cash revenue: 50,000 sandwiches $2 $ 100,000Less: Amounts not yet received 25,000 Cash revenue $ 75,000 Accrual revenue: 50,000 sandwiches $2 $ 100,000

2. Accountants recognize revenue under an accrual accounting system when it is earned. In the catering business, revenue is earned as the sandwiches are deliv-ered to the vendors. Marie’s might consider using the cash method to account for sales of sandwiches if there is a significant amount of uncertainty about the col-lectibility of accounts receivable.



3. Income statement under the accrual basis:

MARIE’S CATERINGINCOME STATEMENT

FOR THE YEAR ENDED XX/XX/XX

Sales revenue $100,000Cost of goods sold 69,600 *

Gross profit $ 30,400 Operating expenses:

Office salaries $ 12,000Equipment depreciation 1,000**Truck depreciation 2,800 ***

Total operating expenses $ 15,800 Net income $ 14,600

*Rent: $800 12 $ 9,600Raw materials 25,000Salaries and wages 35,000 Cost of goods sold $69,600

**$10,000/10 years***$14,000/5 years


LO 3,4 PROBLEM 4-9A REVENUE AND EXPENSE RECOGNITION

Income statements for the first two years:

SUE’S AUDIO BOOK RENTALSINCOME STATEMENTS

Year 1 Year 2Sales revenue (a) $ 21,000 $ 63,000 Expenses:

Advertising (b) $ 6,000 $ 4,500Salaries 0 12,000Depreciation (c) 2,500 2,500Rent (d) 9,000 9,000

Total expenses $ 17,500 $ 28,000 Net income $ 3,500 $ 35,000

Explanations:

a. Let X = Year 1 sales:

Year 1 sales + 3(Year 1 sales) = $84,000

4X = $84,000

X = $21,000 = Year 1 sales

3X = $63,000 = Year 2 sales

b. Total advertising expense $10,500

Less promotional portion 1,500

Total ad expense $ 9,000 or $4,500/year

Year 1 advertising = $4,500 + $1,500 = $6,000

Year 2 advertising = $4,500

c. Depreciation per year = $5,000/2 = $2,500/year

d. Rent per year = $18,000/2 = $9,000/year


LO 5,6 PROBLEM 4-10A ADJUSTMENTS AND FI-NANCIAL STATEMENTS

1. Adjustments:



a. Prepaid Insurance Expense (750) Insurance (750)



b. Accumulated Depreciation Depreciation— Expense— Warehouse (150) Warehouse (150)



c. Accumulated Depreciation Depreciation— Expense— Truck Fleet (3,125) Truck Fleet (3,125)



d. Interest Payable 375 Interest Expense (375)



e. Customer Freight Revenue 4,500Deposits (4,500)



f. Wages and Wages and Salaries SalaryPayable 8,200 Expense (8,200)



g. Income Taxes Income Tax Payable 9,237 Expense (9,237)

PROBLEM 4-10A (Continued)


Explanations for adjusting entry amounts:

(a) $18,000/24 months = $750/month

(b) ($40,000 – $4,000)/240 months = $150/month

(c) ($240,000 – $15,000)/72 months = $3,125/month

(d) ($50,000 9%) 1/12 = $375

(g) Calculation of income tax expense:Freight revenue $ 170,170Gas and oil expense (57,330)Maintenance expense (26,400)Wage and salary expense (51,250)Insurance expense (750)Depreciation on warehouse (150)Depreciation on truck fleet (3,125)Interest expense (375 )Income before tax $ 30,790 Tax rate 0.30

Income tax expense $ 9,237

2. Financial statements:

(a) TENFOUR TRUCKING COMPANYINCOME STATEMENT


Freight revenue $ 170,170Expenses:

Gas and oil $ 57,330Maintenance 26,400Wages and salaries 51,250Insurance 750Depreciation—warehouse 150Depreciation—truck fleet 3,125Interest 375Income taxes 9,237 148,617

Net income $ 21,553

(b) TENFOUR TRUCKING COMPANYSTATEMENT OF RETAINED EARNINGS


Beginning balance, January 1, 2007 $40,470Add: Net income 21,553

$62,023Deduct: Cash dividends 20,000 Ending balance, January 31, 2007 $ 42,023


PROBLEM 4-10A (Continued)

(c) TENFOUR TRUCKING COMPANYBALANCE SHEETJANUARY 31, 2007


Cash $ 27,340Accounts receivable 41,500Prepaid insurance 17,250


Land $ 20,000Warehouse $ 40,000

Less: Accumulated depreciation 21,750 18,250

Truck fleet $ 240,000Less: Accumulated

depreciation 115,625 124,375 Total property, plant, and

equipment 162,625 Total assets $ 248,715

LiabilitiesCurrent liabilities:

Accounts payable $ 32,880Notes payable 50,000Interest payable 4,875Customer deposits 1,500Wages and salaries payable 8,200Income tax payable 9,237

Total current liabilities $ 106,692 Total liabilities $ 106,692

Stockholders’ EquityCapital stock $ 100,000Retained earnings 42,023

Total stockholders’ equity 142,023 Total liabilities and stockholders’

equity $ 248,715



3. Current ratio = Current assets/Current liabilities

$86,090/$106,692 = 0.81 to 1

Tenfour may have difficulties in meeting all of its current obligations. Especially noteworthy is the significantly higher amount of accounts receivable at year-end compared with cash (cash and accounts receivable constitute 32% and 48% of the current assets, respectively). It is also worth noting that the other 20% of the cur -rent assets consists of prepaid insurance, an asset that will not be converted into cash and thus will not help in any way to pay the current liabilities.

4. Tenfour cannot compute a gross profit ratio because it does not report cost of sales. It is a service business rather than a product company. One possible mea-sure of profitability for any company is the profit margin, which is net income di-vided by sales. For Tenfour, this ratio is $21,553/$170,170 or 12.7%. Many service businesses calculate ratios that are specific to their type of business. For example, a trucking firm might compute the ratio of revenues to miles driven.

D E C I S I O N C A S E S

READING AND INTERPRETING FINANCIAL STATEMENTS

LO 1,2,3 DECISION CASE 4-1 COMPARING TWO COMPANIES IN THE SAME INDUSTRY: FINISH LINE AND FOOT LOCKER

1. According to Note 1 in its annual report, Finish Line recognizes revenue when the customer receives the merchandise. Foot Locker indicates in its Note 1 that revenue from stores is recognized when the product is delivered to customers. The compa-nies have essentially the same policy for the recognition of revenue.

2. On its February 25, 2006, balance sheet, Finish Line reports Accounts receivable, net of $11,999,000. This comprises only $11,999,000/$627,816,000, or 1.9% of the company’s total assets. The reason that this percentage is so small is because cus-tomers in a store such as Finish Line usually pay with either cash or a credit card.

3. In Foot Locker’s annual report, Note 8, titled “Other Current Assets” includes “Net re-ceivables” of $49,000,000 at January 28, 2006 (the note also reports the “Current portion of Northern Group note receivable” of $1,000,000). These receivables to-gether represent only $50,000,000/$3,312,000,000, or 1.5% of total assets on this date.

DECISION CASE 4-1 (Concluded)


4. The two approaches differ in that Foot Locker chooses to report a single Property and Equipment account on its balance sheet with Note 9 showing the individual amounts for the items, such as furniture, fixtures, and equipment, which make up this asset. Companies have flexibility as to whether they report this information di-rectly on the balance sheet or instead in one of the notes to the statements.

LO 3 DECISION CASE 4-2 READING AND INTERPRETING SEARS, ROEBUCK’S NOTES—REVENUE RECOGNITION

1. Under the accrual basis, revenue should be recognized when it is earned rather than when cash is received. Over the life of a service contract, the retailer will incur costs to repair damaged merchandise. The retailer earns revenue over the life of the service contract.

2. Revenue to be recognized each year:

Year 1 Year 2 Year 3 Total

Sales revenue $2,320* $ 0 $ 0 $ 2,320

Service contract revenue 60 ** 60 60 180

Total revenue $ 2,380 $ 60 $ 60 $ 2,500

*$2,500 – $180

**$180/3 years

When a retailer sells a service contract, it receives cash and at the same time in-curs a liability to provide service in the future. Thus, on its balance sheet, it will re -port a liability account for work to be performed under service contracts—a form of unearned revenue. This account tells the reader the amount of revenue to be rec-ognized in the future under service contracts.

In this particular example, the liability account would contain $120 and $60 at the end of Years 1 and 2, respectively, to report the amount of unearned revenue.


MAKING FINANCIAL DECISIONS

LO 2,3,4 DECISION CASE 4-3 THE USE OF NET INCOME AND CASH FLOW TO EVALUATE A COMPANY

1. DUKE INC.STATEMENT OF CASH FLOWS

FOR THE YEAR ENDED DECEMBER 31, 2007

Operating Activities:Cash received from services

provided to clients $ 1,020,000*Cash paid for:

Salaries and wages $ 440,000**Supplies 100,000Utilities 30,000Rent 180,000 *** 750,000

Net increase in cash $ 270,000

*$1,250,000 – $230,000

**$480,000 – $40,000

***$10,000 18 months

Note to Instructor: You may want to point out to students that the net increase in cash is also the net cash provided by operating activities for the year. That is, there are no investing or financing activities because the acquisition of the computer system by the signing of a promissory note did not result in any net change in cash, if it is as-sumed that the note was signed directly with the computer vendor. The transaction would not appear directly on a statement of cash flows but instead on a supplementary schedule.

2. One important question to be asked is whether it is possible for the company to con-tinue to generate service revenues in succeeding years at the level attained in its first year. The ability to collect the revenues billed in 2007, but not yet collected ($230,000), should also be a concern. On the basis of the cash flows generated in the first year, the business appears to be worth strong consideration. One major concern, however, is whether the company will be able to repay the note in 2010. It must generate sufficient cash flows over the next three years (this includes the year just concluded) to repay $1,725,000 in principal and $414,000 ($138,000 per year 3 years) in interest. This may be very difficult to do unless more cash flow is gener -ated from operations or the company is able to negotiate an extension of the due date for the loan.


LO 4 DECISION CASE 4-4 DEPRECIATION

The decision to purchase or lease long-term assets is a difficult one for all businesses and requires an analysis of all the relevant facts. Rapidly changing technology may make it less risky to lease computer equipment than to purchase it. This is certainly a key consideration in this particular case. Jenner also needs to consider maintenance costs. The case does not indicate whether Jenner would be responsible for mainte-nance if it leases the equipment. Another relevant factor would be whether the equip-ment would have any salvage value at the end of its useful life.

Note to Instructor: This may be an opportune time to raise the issue whether certain leases should be capitalized as assets. Given the students’ understanding of the nature of an asset, do they think some long-term leases possess the characteristics to qualify for treatment as assets?

Depreciation is the process of allocating the cost of a long-term tangible asset over its useful life. Because of rapidly changing technology, computer equipment presents a challenge to the accountant in determining economic life. Even though the equipment may last for 10 to 20 years before it physically wears out, its economic life may be much shorter than that because of technological obsolescence. In this particular case, a life of three to five years, possibly four years, seems to be warranted.

ETHICAL DECISION MAKING

LO 2,3,4,5 DECISION CASE 4-5 REVENUE RECOGNITION AND THE MATCHING PRINCIPLE

1. If sales are recorded but the commissions associated with these sales are not recorded during the month of June, net income will be larger by the understatement of commissions expense. The failure to record advertising expense for the month of June will also result in an understatement of expense and an overstatement or in-crease in net income. Finally, an increase in the estimated useful life of the auto-mobiles will result in a decrease in the amount of depreciation expense and thus an increase in net income.


DECISION CASE 4-5 (Concluded)

2. The first suggestion, to delay recording the 4% commission expense until July, is a clear violation of the matching principle. Regardless of when the sales staff is paid commissions, it is wrong to record the revenues in June but not record the expense associated with earning that revenue—i.e., commissions—until July. Likewise, de-ferring the recognition of the advertising bill as an expense until July also violates the matching principle. Under the matching principle, this cost should be recog-nized as an expense in the period in which it provides benefits (in this case, the month of June), regardless of when cash is paid. Finally, the change in estimated useful life for the automobiles is also questionable from an accounting point of view. Companies are allowed under generally accepted accounting principles to change estimated useful lives of depreciable assets, but the changes must be justified on sound economic grounds. For example, changes in technology might prompt a company to decrease the estimated useful lives of its computers. The need to in-crease the net income for the year is certainly not an acceptable reason under GAAP to change the estimated useful lives of depreciable assets.

The changes suggested result in financial statements that do not faithfully repre-sent what they claim to represent and are not merely minor bookkeeping changes. Readers assume that the statements are prepared on an accrual basis rather than a cash basis. Also, they assume that the company is consistent in the way it depre-ciates assets from one period to the next.

3. Each of the three suggestions involves a question of ethics. All three involve an at-tempt to consciously overstate income for the purpose of obtaining a loan, and the decisions made by the owners provide information that is biased toward making the company look better. There is an attempt on the part of the vice-president of sales to deceive a user of the accounting information. The banker relies on the trustwor-thiness of the company to accurately report its income, and each of the three sug-gestions would violate that trust. The company would not be acting in good faith if it were to report income as has been suggested. The vice-president has suggested changes that are intended to overstate net income for the purpose of receiving the loan.

4. The controller may benefit in the short-term by making the proposed changes (he gets to keep his job and his Cadillac). But in the long-term his professional reputa-tion will be harmed when the bank realizes that he misstated income to mislead the bank and receive the loan. If the bank approves the loan based on overstated net income, the bank will be harmed. The interest rate of the loan will not properly re-flect the risk of the company. Any outsiders who rely on the financial statements will be harmed. When net income is overstated, future cash flows are also overstated and outsiders who rely upon the incorrect financial statements may make the wrong decisions about the company (e.g., extend credit when they should not).


LO 4 DECISION CASE 4-6 ADVICE TO A POTENTIAL INVESTOR

The financial statements contain two major errors that prevent them from being in ac-cordance with generally accepted accounting principles. First, if the normal balance of supplies on hand is $1,000, Century should recognize supplies expense on its income statement for $16,500 (the amount of supplies on its balance sheet) less $1,000, or $15,500. Second, it should also recognize depreciation expense of $35,000 over seven years, or $5,000, on the equipment. These two adjustments would result in revised net income as follows:

Net income reported $ 10,500Supplies expense (15,500)Depreciation expense (5,000 )Revised net income (loss) $ (10,000 )

The company was able to generate significant revenues from its services during the first year. Given this level of revenues, however, it was not able to control its costs, par-ticularly its salaries and wages. On the basis of these financial statements alone, it would be difficult to advise anyone to invest in the company. In addition to the informa-tion given, the investor would want to know more about the nature of the company's business (its markets, customers, pricing structure, etc.) and the industry in which it op-erates.

REAL WORLD PRACTICE 4.1

Foot Locker reports in Note 8 “Prepaid expenses and other current assets” of $47,000,000 and $46,000,000 at the end of 2004 and 2005, respectively. The types of prepaid expenses a company such as this might have include various prepayments, such as insurance and rent, and various types of supplies, such as cleaning and office supplies.

REAL WORLD PRACTICE 4.2

According to Note 11 “Accrued Liabilities” in Foot Locker’s report, the largest item at the end of 2004 was “Other operating costs” and the amount was $55,000,000. At the end of 2005, the largest item was “Pension and postretirement benefits” of $72,000,000. The account “Accrued and other liabilities” appears as a current liability on the balance sheet. The total amounts for accrued liabilities in the note are $285,000,000 and $305,000,000 at the end of 2004 and 2005, respectively. These same amounts appear on the balance sheets at the end of the two years.


SOLUTION TO INTEGRATIVE PROBLEM

Part 1

1. Effects on the accounting equation are as follows:



a. Salary and Salary and Wages Payable 4,000 Wages Expense (4,000)



b. Medical Supplies Supplies (64,347) Expense (64,347)



c. Accumulated Depreciation Depreciation— Expense—Automobiles (30,000) Automobiles (30,000)



d. Accumulated Depreciation Depreciation— Expense—Building (10,000) Building (10,000)



e. Extended Extended WarrantyWarranty (3,000) Expense (3,000)



f. Billings Receivable, Medical ServicesNet 16,000 Revenue 16,000



g. Interest Payable 3,000 Interest Expense 3,000


INTEGRATIVE PROBLEM (Continued)

2. MOUNTAIN HOME HEALTH INC.INCOME STATEMENT


Revenues:Medical services revenue $ 566,000

Expenses:Salary and wages expense $292,000Supplies expense 64,347Gasoline expense 137,500Utilities expense 12,000Interest expense 3,000Depreciation expense—automobiles 30,000Depreciation expense—building 10,000Extended warranty contract expense 3,000

551,847 Net income $ 14,153

MOUNTAIN HOME HEALTH INC.RETAINED EARNINGS STATEMENT


Beginning balance $ 99,900Add: Net income 14,153Deduct: Dividends (10,000 )Ending balance $ 104,053


INTEGRATIVE PROBLEM (Continued)

3. MOUNTAIN HOME HEALTH INC.BALANCE SHEET

AS OF DECEMBER 31, 2006


Cash $ 77,400Billings receivable, net 167,000Medical supplies 8,653


Building $ 200,000Less: Accumulated depreciation (60,000 ) 140,000

Total assets $ 393,053

Liabilities and Stockholders’ EquityCurrent liabilities:

Accounts payable $ 22,000Interest payable 3,000Salary and wages payable 4,000Dividend payable 10,000

Total current liabilities $ 39,000Long-term liabilities:

Mortgage payable 100,000 Total liabilities $ 139,000

Stockholders’ EquityCapital stock $ 100,000Additional paid-in capital 50,000Retained earnings 104,053

Total stockholders’ equity 254,053 Total liabilities and stockholders’ equity $ 393,053

4. a. Working capital: $253,053 – $39,000 = $214,053

b. Current ratio: $253,053/$39,000 = 6.5 to 1

5. By their nature, all adjustments cause a difference between the amount of income recognized on an accrual basis and that recognized on a cash basis. The adjust-ment for wages and salaries, and interest, result in decreases in income in the cur-rent period with a delay in the outflow of cash until a later period. Similarly, the ad -justment for service revenue represents revenue earned currently but delayed until a later period in the receipt of cash. Conversely, the adjustments for depreciation, warranties, and supplies used represent the recognition of expense in the current period for cash outlays in an earlier period.


INTEGRATIVE PROBLEM (Concluded)

6. Supply of cash needed:

Salaries: $800 per day 7 days per week 7 weeks = $ 39,200Supplies: $1,500 per week 7 weeks = 10,500Gasoline: $375 per day 7 days per week 7 weeks = 18,375 Supply of cash needed for 7 weeks = $ 68,075

porter sm ch. 04_2pp

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