practice problems i(1)

Financial AccountingACCT 5011, Fall A 2014Tom Fields

Here are about 20 inference problems similar to those in Notes 4 that we covered in class on August 18th. These are NOT assigned as homework, and are NOT required. They are available as additional problems for any student who would like more practice. There are four sections; section 1 has missing data (Type I) inference problems; sections 2 & 3 have missing transaction (Type II) inference problems - the problems in section 3 are significantly more difficult than those in section 2. Finally, section four has a few alternate accounting (Type III) problems similar to the AOL or Microsoft cases (which we will cover in classes 6 and 7 respectively). For the quiz, focus on the first three sections, and don’t worry about revenue recognition issues; all four sections will be relevant for the midterm.

In section 1, the key is to know all of the items which affect a given account, and the use the T-account approach to solve for what you do not know. In sections 2 & 3, the key is to understand the journal entries – both as actually done, and as they should have been done. Once you’ve done that, determining the effect on the financial statements should be relatively straightforward. In section 4, you again want to write out the journal entries under both the actual and the alternate approach; possibly use the techniques in section 1 to solve for any missing data, and then adjust the financial statements as needed. Solutions to all problems are included at the end of the handout.

You can also see the sample quizzes for a few more examples of questions similar to those in Section 1 and Section 3.

Section 1: Missing Data. Use the balance sheet and income statement for Walgreens’ (year ended August 31, 2013). DO NOT use information from any other statements.

a. Determine the total cash collected from credit customers during 2013 - these are insurance companies paying for prescription drugs. Assume that 63% of net sales were made on credit. Assume that there are no write-offs for uncollectible accounts (something we’ll discuss later in the course).

b. Assume that the entire balance of “Other current assets” represents prepaid rent. If rent expense during 2013 was $2,571, how much rent did Walgreens PAY during 2013?

c. Assume that Walgreens purchased $1,212 worth of “Property and Equipment” during 2013, and did not sell any. What was their depreciation expense for the year (note that you can’t determine the solution directly from the income statement because depreciation is buried in Selling, general and administrative expenses)?

d. Assume that the account “accrued expenses and other liabilities” includes a liability for dividends payable that totals 354 at the end of 2013, and 282 at the end of 2012. We know from the example that we did in the notes (see slide 11 from Notes 4) that dividends declared during the year were 1083. What were dividends paid?

Section 2: Effect of Errors (Basic). Use the balance sheet and income statement for Walgreens’ (year ended August 31, 2013). DO NOT use information from any other statements. The following events, which occurred during the year ended August 31, 2013, were accidentally not recorded. No adjusting entries relating to these transactions were recorded either. Treat each question independently, and ignore income tax effects. All numbers are in millions (as are the numbers in the financial statements).

a. In January 2013, Walgreens paid $5 cash to its suppliers, in order to settle some of its accounts payables.

b. During March 2013 Walgreens purchased land worth $10. Walgreens paid $2 in cash and took out a loan for the remaining amount. Assume that the entire loan is non-current.

c. On June 1, 2013, Walgreens paid $12 for insurance. The policy covers the period June 1, 2013 to May 31, 2014.

d. In June 2013, Walgreens issued (i.e., sold) $20 in common stock for cash.

e. Total credit sales on July 4, 2013 were $22. The cost of the inventory sold was $18.

f. In August 2013, Walgreens declared (but did not pay) a $354 dividend on its common stock. The payment will be made in September 2013.

g. For the month of August 2013, there were electric utility bills of $2, which were not paid until September 2013.

h. During August 2013, $1 was received from an insurance company as payment for prescriptions which would not be filled (and thus recorded as revenues) until September 2013.

For each part (a-h) answer the following questions. If the appropriate adjustment were made to correct for the omission, what would be

i) Walgreens’ total assets at August 31, 2013?ii) Walgreens’ total current liabilities at August 31, 2013?iii) Walgreens’ total shareholders’ equity at August 31, 2013?iv) Walgreens’ net earnings for the year ended August 31, 2013?

ACCT 5011 – Financial Accounting

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Section 3: Effect of Errors (Advanced). Use the balance sheet and income statement for America Online (year ended June 30, 1996), which are included in the AOL (B) case (DO NOT use information from any other statement). The following events, which occurred during the year ended June 30, 1996, were recorded incorrectly. Treat each question independently, and ignore income tax effects. All numbers are in thousands (as are the numbers in the financial statements).

a. In June, 1995, AOL correctly accrued for wages earned during fiscal 1995, but not to be paid until July 1995. In July, 1995, AOL paid these wages (totaling $5,000) but recorded them using the following entry:

Wage Expense (+E, -SE) 5,000 Cash (-A) 5,000

b. In December 1995, AOL collected $500 in cash on trade accounts receivable relating to sales previously made (and correctly recorded). AOL recorded this cash receipt as:

Cash (+A) 500 Revenue (+R, +SE) 500

c. On January 1, 1996, AOL spent $4,000 cash to purchase certain license rights. These rights have a useful life of 2 years (24 months) and no value at the end of that period. AOL’s policy is to capitalize these costs and spread them evenly over the useful life; however, AOL accidentally expensed these costs immediately.

d. Cash subscription fees totally $800 were received on April 1, 1996, for services to be provided between April 1, 1996 and March 31, 1997. All $800 were recorded as revenue on April 1, 1996. Assume the all costs were recorded correctly.

e. AOL was engaged during fiscal 1996 for a two-year consulting project. Total fees were agreed to be $10, all of which would be paid in fiscal 1997. Total costs were expected to be (and were) $6, half paid in 1996 and half in 1997. Assume that all costs were for cash. In 1996, AOL recorded this project using the percentage of completion method, even though corporate policy was to use the completed contract method for such projects.

For each part (a-e) answer the following questions. If the appropriate adjustment were made to correct for the error, what would be

i) AOL’s total assets at June 30, 1996?ii) AOL’s total liabilities at June 30, 1996?iii) AOL’s total stockholders’ equity at June 30, 1996?iv) AOL’s net income for the year ended June 30, 1996?


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Section 4: Alternate Accounting. We did (or will do) two of these problems in class (AOL and Microsoft). In both of these examples, the firm is using accrual accounting to separate the effect of cash flows and income. The problem is then to “undo” this accrual in order to restate the financial statements as if the firm had never used this method. As we saw in the two key slides from Notes 4 and Notes 5, there are only 4 possibilities here:

1. Pay cash now, but record expense later (AOL Case)2. Record expense now, but pay cash later3. Receive cash now, but record revenue later (Microsoft Case)4. Record revenue now, but receive cash later

In each of these cases the careful way to do it is to follow the three steps first laid out in Notes 4 (slide 15): prepare the journal entries under each method; solve for any missing data; determine the effect of the difference.

Roughly speaking, what we end up doing in each case is:

1) adjusting the I/S by the change in the balance sheet accrual account and 2) adjusting the balance sheet by the cumulative amount in the balance sheet account.

a. Refer to the 2013 Walgreens balance sheet and income statement. From footnote 16, we can see that the accrued expenses and other liabilities line on the balance sheet includes $928 and $772 in accrued salaries for August 31, 2013 and August 31, 2012, respectively. These represent salaries already earned by employees at those dates (and therefore expensed) but not yet paid by Walgreens. If Walgreens had always used cash basis accounting for salaries, what would their 2013 net income have been? Here, cash basis accounting means that the expense would be recorded when cash was actually paid, regardless of when the work is performed.

If you can’t solve the problem as given, try adding the additional assumption that Walgreens paid $772 in 2013 for salaries earned in 2012 and that they paid $928 in 2014 for salaries earned in 2013. This assumption is reasonable, but it is NOT necessary.

b. Refer to the AOL financial statements for the year ended June 30, 1996 (included in the course packet with the AOL case). Assume that “prepaid expenses and other current assets” refers to entirely to prepaid rent. If AOL had always used a cash basis for its rent expense (i.e., if AOL simply expensed rent when paid, rather than when incurred), what would have been their 1996 net income? What would have been their total assets, total liabilities and total shareholders’ equity at the end of 1996?

c. Refer to the 2013 Walgreens balance sheet and income statement. Walgreens records revenue for prescription sales at the time of sale, even though cash is received later. If Walgreens had always used a cash basis for recording such revenue (i.e., if they recorded revenue only when cash was actually received), what would have been their net income for the year ended August 31, 2013, and their total assets, total liabilities, and total shareholders’ equity at the end of 2013? Assume, in violation of the matching principle, that the cost of goods sold was still recorded at the time of sale, and assume that there are no write-offs for uncollectible accounts. You should be able to do the problem without referring to problem a) from section 1.


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Solutions – Section 1: Missing Data

a. The journal entries for credit customers look like:

A/R (+A) X Cash (+A) Y Sales (+R, +SE) X A/R (-A) YWhen sales on account are made (there will also When cash is collectedbe a cost of sales entry here, which does not affect our problem)

We want to solve for Y, and since Cash won’t be much help, we will analyze Accounts Receivable.

Accounts Receivable (A)BB 2,167Sales X Y CollectionsEB 2,632

Thus, 2,167+X–Y=2,632, or Y = 2167+X–2632.We can compute X as 63% x 2013 Net Sales = 0.63 x 72,217 = 45,497.Then Y (our answer) = 2167+45497–2632 = 45,032.

b. The journal entries for rent look like:

Prepaid Rent (+A) X Rent Expense (+E, -SE) Y Cash (-A) X Prepaid Rent (-A) YWhen cash is paid When the expense is incurred

We want to solve for X, and since Cash won’t be much help, we will analyze Prepaid Rent.

Prepaid Rent (A)BB 260Pymt X Y=2571 ExpenseEB 284

Thus, 260+X–Y=284, or X = 284+Y–260.Then X (our answer) = 284+2571–260 = 2595.


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c. The journal entries for PE (Property & equipment) look like:

Property and Equipment (+A) X Depreciation Expense (+E, -SE) Y Cash (-A) X Property and Equipment (-A) YWhen PPE is purchased When depreciation is recorded

There is no sales entry as none was sold. We want to solve for Y, and since Cash won’t be much help, we will analyze Property and Equipment. Note that this account is reported net, i.e., net of accumulated depreciation.

Property & Equipment (A)BB 12,038Purch X=1,212 Y DepreciationEB 12,138

Thus, 12,038+X–Y =12,138, or Y=12,038+X–12,138.Then Y (our answer) = 12038+1212–12138 = 1,112.

d. The journal entries for dividends look like:

Retained Earnings (-SE) X Dividends Payable (-L) Y Dividends Payable (+L) X Cash (-A) YWhen dividends are declared When dividends are paid

We want to solve for Y, and since Cash won’t be much help, we will analyze Dividends Payable.

Dividends Payable (L)282 BB

Paid Y X = 1,083 Declared354 EB

Thus, 282+X–Y=354, or Y=282+X–354.Then Y (our answer) = 282+1083–354 = 1011.


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Solutions - Section 2: Effect of Errors (Basic)

In all of the cases in this section, the “actual” journal entry is NONE, and so the adjustment is just the “correct” entry.

a. Accounts Payable (-L) 5 Cash (-A) 5

Assets decrease by 5: 35481 – 5 = 35476Current Liabilities decrease by 5: 8883 – 5 = 8878Shareholders’ Equity is not changed: 19454 = 19454Net Earnings are not changed: 2450 = 2450

b. Land (+A) 10 Cash (-A) 2

Mortgage (+L) 8

Assets increase by 10-2: 35481 + 8 = 35489Current Liabilities are not changed: 8883 = 8883Shareholders’ Equity is not changed: 19454 = 19454Net Earnings are not changed: 2450 = 2450

c. Insurance Expense (+E, -SE) 3 (June, July and August, 2013)Prepaid Insurance (+A) 9 (September 2013 through May 2014) Cash (-A) 12

Assets decrease by 12-9 = 3: 35481 – 3 = 35478Current Liabilities are not changed: 8883 = 8883Shareholders’ Equity decreases by 3: 19454 – 3 = 19451Net Earnings decrease by 3: 2450 – 3 = 2447

d. Cash (+A) 20 Common Stock (+SE) 20

Assets increase by 20: 35481 + 20 = 35501Current Liabilities are not changed: 8883 = 8883Shareholders’ Equity increases by 20: 19454 + 20 = 19474Net Earnings are not changed: 2450 = 2450


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e. Accounts Receivable (+A) 22 Sales Revenue (+R, +SE) 22Cost of Goods Sold (+E, -SE) 18 Inventory (-A) 18

Assets increase by 22-18=4: 35481 + 4 = 35485Current Liabilities are not changed: 8883 = 8883Shareholders’ Equity increases by 22-18=4: 19454 + 4 = 19458Net Earnings increase by 22-18=4: 2450 + 4 = 2454

f. Retained Earnings (-SE) 282 Dividends Payable (+L) 282

Assets are not changed: 35481 = 35481Current Liabilities increase by 354: 8883 + 354 = 9237Shareholders’ Equity decreases by 354: 19454 – 354 = 19100Net Earnings are not changed: 2450 = 2450

g. Utilities Expense (+E, -SE) 2 Utilities Payable (+L) 2

Assets are not changed: 35481 = 35481Current Liabilities increase by 2: 8883 + 2 = 8885Shareholders’ Equity decreases by 2: 19454 – 2 = 19452Net Earnings decrease by 2: 2450 – 2 = 2448

h. Cash (+A) 1 Deferred Revenue (+L) 1

Assets increase by 1: 35481 + 1 = 35482Current Liabilities increase by 1: 8883 + 1 = 8884Shareholders’ Equity is not changed: 19454 = 19454Net Earnings are not changed: 2450 = 2450


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Solutions - Section 3: Effect of Errors (Advanced)

In this section, it helps to write out both the actual journal entry and the correct journal entry. The difference between the two is then the “adjustment”.

a. ACTUAL: Wage Expense (+E, -SE) 5,000 Cash (-A) 5,000

CORRECT: Wage Payable (-L) 5,000 Cash (-A) 5,000

ADJUST: Wage Payable (-L) 5,000 Wage Expense (-E, +SE) 5,000

Assets are not changed: 958754 = 958,754Liabilities decrease by 5000: 446252 - 5000 = 441,252Stockholders’ Equity increases by 5000: 512502 + 5000 = 517,502Net Income increases by 5000: 29816 + 5000 = 34,816

b. ACTUAL: Cash (+A) 500 Revenue (+R, +SE) 500

CORRECT: Cash (+A) 500 Accounts Receivable (-A) 500

ADJUST: Revenue (-R, -SE) 500 Accounts Receivable (-A) 500

Assets decrease by 500: 958754 – 500 = 958,254Liabilities are not changed: 446252 = 446,252Stockholders’ Equity decreases by 500: 512502 – 500 = 512,002Net Income decreases by 500: 29816 – 500 = 29,316

c. ACTUAL: Expense (+E, -SE) 4,000 Cash (-A) 4,000

CORRECT: License Rights (+A) 3,000 (18 months)Expense (+E, -SE) 1,000 (6 months) Cash (-A) 4,000

ADJUST: License Rights (+A) 3,000 Expense (-E, +SE) 3,000

Assets increase by 3000: 958754 + 3000 = 961,754Liabilities are not changed: 446252 = 446,252Stockholders’ Equity increases by 3000: 512502 + 3000 = 515,502Net Income increases by 3000: 29816 + 3000 = 32,816


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d. ACTUAL: Cash (+A) 800 Revenue (+R, +SE) 800

CORRECT: Cash (+A) 800 Revenue (+R, +SE) 200 (3 months) Deferred Revenue (+L) 600 (9 months)

ADJUST: Revenue (-R, -SE) 600 Deferred Revenue (+L) 600

Assets are not changed: 958754 = 958,754Liabilities increase by 600: 446252 + 600 = 446,852Stockholders’ Equity decreases by 600: 512502 – 600 = 511,902Net Income decreases by 600: 29816 – 600 = 29,216

e. ACTUAL: Receivable (+A) 5 Revenue (+R, +SE) 5Cost of Goods Sold (+E, -SE) 3 Cash (-A) 3

CORRECT: “Inventory” (+A) 3 Cash (-A) 3

ADJUST: Revenue (-R, -SE) 5 Receivable (-A) 5“Inventory” (+A) 3 Cost of Goods Sold (-E, +SE) 3

Assets decrease by 5-3 = 2: 958754 – 2 = 958,752Liabilities are not changed: 446252 = 446,252Stockholders’ Equity decreases by 5-3=2: 512502 – 2 = 512,500Net Income decreases by 5-3=2: 29816 – 2 = 29,814


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Solutions - Section 4: Alternate Accounting

a. Accrued Salaries at Walgreens.

Under the existing accounting, there are three transactions relating to Salaries. During fiscal year 2013:

Accrued Salaries (-L) XCash (-A) X

• X represents salaries paid for in 2013, even though the work was actually done (and thus the expense was recorded) in 2012. That is, the expense is recognized before cash is paid.

Salaries Expense (+E, –SE) YCash (-A) Y

• Y represents salaries paid for in 2013, for work done in 2013. That is, the expense is recognized and cash is paid in the same period. As we’ll see momentarily, this could actually be skipped without changing our answer.

Salaries Expense (+E –SE) ZAccrued Salaries (+L) Z

• Z represents work done in 2013, but that will not be paid for until 2014. That is, the expense is recognized before cash is paid.

Under cash basis accounting, no transaction would be made in 2013 for the salaries paid in 2014 (Z), but the other two transactions would be recorded as:

Salaries Expense (+E, –SE) XCash (-A) X

Salaries Expense (+E, –SE) YCash (-A) Y

In moving from the first set of transactions to the second, we see that Walgreens avoids expense of Z and incurs an additional expense of X. The expense of Y is paid under both methods and so does not cause a change. Under the existing accounting, Walgreens’ income statement shows net income of 2450. Thus, Walgreens’ 2013 net income under the alternate accounting would have been: 2450 + Z – X. In order to get a specific number, we need to know Z – X.


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But this can be obtained by analyzing the Accrued Salaries liabilities account under the actual method:

Accrued Salaries (L)Beginning Balance 772

X Z

Ending Balance 928

The beginning and ending balance are obtained from the problem.Solving the equation: 772 + Z – X = 928 tells us that Z – X = $156. Thus, the alternate net income would have been: 2450+156 = $2,606.

The question did not ask for the balance sheet effect, but it isn’t hard. Under the alternate method, “Accrued Expenses and Other Liabilities” would be lower by $928, and thus total liabilities would be lower by the same amount. Retained Earnings (and thus total shareholders’ equity) would be higher by $928, in order to keep the balance sheet in balance.


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b. Prepaid rent at AOL

Under the existing accounting, there are two transactions relating to prepaid rent. During fiscal year 1996:

Prepaid Rent (+A) XCash (-A) X

• X represents rent paid during 1996.

Rent Expense (+E, -SE) YPrepaid Rent (-A) Y

• Y represents rent “used”, and therefore expensed during 1996.

Under cash basis accounting, the rent expense would be the same as the rent paid:

Rent Expense (+E, -SE) XCash (-A) X

In moving from the first set of transactions to the second, we see that AOL avoids expense of Y and incurs an additional expense of X. Under the existing accounting, AOL’s income statement shows net income of 29,816. Thus, AOL’s 1996 net income under the alternate accounting would have been: 29,816 + Y – X. In order to get a specific number, we need to know Y – X. But this can be obtained by analyzing the Prepaid Rent account under the actual method:

Prepaid Rent (A)Beginning Balance 25,527

XY

Ending Balance 68,832

The beginning and ending balance are obtained from the balance sheet (using the assumption that the “prepaid expenses and other current assets” account refers entirely to prepaid rent).Solving the equation: 25,527 + X – Y = 68,832 tells us that X – Y = $43,305. Thus, the alternate net income would have been: 29,816 – 43,305 = ($13,489).

We can also adjust the balance sheet, by writing off the entire (cumulative) amount of capitalized prepaid rent on the balance sheet, and balancing this against a reduction of retained earnings.

This gives us a summary balance sheet at 6/30/1996 of

Assets 958,754 – 68,832 = 889,922Liabilities 446,252 = 446,252SE 512,502 – 68,832 = 443,670


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c. Accounts Receivable at Walgreens

First, make sure we understand the journal entries. If we do not use problem a) from section 1, the best we can do is:

ACTUAL:Accounts Receivable (+A) X Net Sales (+R, +SE) X

Cash (+A) Y Accounts Receivable (-A) Y

ALTERNATE:No entry at delivery

Cash (+A) Y Net Sales (+R, +SE) Y

Starting with the income statement, we see that as we move from the actual to the alternate, revenues increase by Y and decrease by X. Thus revenues (and NI) increase by Y-X.

Now set up the T-account and solve for the difference between X and Y.

Accounts Receivable (A)BB 2,167

X YEB 2,632

Thus, 2,167 + X – Y = 2,632 or X – Y = 465.

Net income under actual is 2,450 (from the income statement). Alternate net income is 2,450 + Y -– X = 2,450 – 465 = 1,985.

We can also adjust the balance sheet, by writing off the entire (cumulative) amount of accounts receivable on the balance sheet, and balancing this against a reduction of retained earnings.

This gives us a summary balance sheet at 8/31/13 of

Assets 35,481 – 2,632 = 32,849Liabilities 16,027 = 16,027SE 19,454 – 2,632 = 16,822


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practice problems i(1)

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