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CHAPTER 3—THE BASICS OF ADJUSTING ENTRIES—8th Edition

Study Objectives—after studying the chapter, you should be able to:


1. Explain the time period assumption.
2. Explain the accrual basis of accounting.
3. Explain why adjusting entries are needed.
4. Identify the major types of adjusting entries.
5. Prepare adjusting entries for deferrals (prepayments).
6. Prepare adjusting entries for accruals.
7. Describe the nature and purpose of an adjusted trial balance.
8. Prepare adjusting entries for the alternative treatment of prepayments.

INTRODUCTION: Take the following Quiz on Adjusting Entries and then


check the answers on the last page of the lecture notes after you have
studied this chapter:

T or F: Adjusting entries are made to apply the matching principle.


T or F: The Cash account is found in some adjusting entries.
T or F: All adjustments affect both the Balance Sheet and the Income
Statement.

Matching from types of Adjusting Entries: (1) Accrued expense; (2)


Accrued revenue; (3) Deferred expense; and (4) Deferred revenue:
____ Unpaid salaries
____ Rent received in advance
____ Prepaid insurance
____ Interest earned but not received
____ Rent paid in advance
____ Subscriptions received in advance
____ Rent due to us
____ Unpaid interest

I. Definitions and Key Concepts—Refer to handout, page 1 (3-17)—


ILLUSTRATION 3-1: GUIDELINES TO REPORT REVENUES AND
EXPENSES noting on the handout that the Accrual Basis Accounting applies the
three principles explained there.
A. Define the cash basis and the accrual basis of accounting:
1. Cash basis—an accounting method in which an expense is recorded when
cash is paid and revenue is recorded when cash is received. Cash-basis
accounting is NOT in accordance with GAAP.
2. Accrual basis—an accounting method in which an expense is recorded
when it is incurred and revenue is recorded when it is earned. It is the basis
of accounting in which transactions that change a company’s financial
statements are recorded in the periods in which the events occur.

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B. Define the matching principle.
1. Matching principle—the accounting principle that states that revenue
earned during an accounting period should be offset by the expenses that were
incurred in earning that revenue. The principle that efforts (expenses) be
matched with accomplishments (revenues).
2. How to apply the matching principle—at the end of the accounting
period expenses and revenues must be examined to find out what amounts
belong to the period regardless of when the related cash payments and receipts
occur which means you will need to adjust both expenses and revenues in
order to apply the matching principle.
3. To determine Accrual Net Income:
All Recognized Revenues
All Matched Expenses
Recognized Revenues - Matched Expenses = Accurate net income for the period

C. Define the time period assumption:


1. An assumption that the economic life of a business can be divided into
artificial time periods.
2. Refer to the anecdote on pages 89-90 illustrating one way to compute
lifetime income. Although the old grocer may be correct in his evaluation, it
is impractical to wait so long for the results of operations:
a) Management usually wants monthly financial statements.
b) Internal Revenue Service (IRS) requires all businesses to file
annual tax returns.
D. Fiscal and Calendar Years:
1. Accounting time periods are generally a month, a quarter, or a year.
Monthly and quarterly time periods are called interim periods—less than
one year.
2. Fiscal year—an accounting period that is one year in length. A fiscal year
usually begins on the first day of a month and ends twelve months later on
the last day of a month.
3. Calendar year—an accounting period that extends from January 1 to
December 31.
E. Define the revenue recognition principle:
1.The principle that revenue be recognized in the accounting period in
which it is earned.
2. In a service enterprise, revenue is considered to be earned at the time the
service is performed.
F. Define accruals and deferrals.
1. Accruals—Expenses incurred and revenue earned in the current
accounting period but not recorded as of the end of the period. To accrue
means to build up or to accumulate. Thus, an accrual is a buildup or
accumulation of revenue or an expense that has not been recorded by a
routine journal entry.

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2. Deferrals—Expenses and revenues that have been recorded in the
current accounting period but are not incurred or earned until a future
period. To defer means to put off or to postpone. Thus a deferral is a putting
off or a postponement of revenue or an expense that has been recorded by a
routine journal entry but belongs to the future.
G. Define the Going Concern Concept—financial reports of a business are
prepared with the expectation that the business will remain in operation
indefinitely. Since this concept assumes that a business will continue indefinitely
into the future, by accruing expenses and revenues, it is understood that the
business has a future.
H. The Basics of Adjusting Entries:
1. Adjusting entries are entries made at the end of an accounting period
to ensure that the revenue recognition and matching principles are
followed.
2. Adjusting entries are required every time financial statements are
prepared and are dated as of the balance sheet date.
3. Adjusting entries are needed because:
a) Some events are not journalized daily because it is
inexpedient to do so. Examples are the consumption of supplies and
the earning of wages by employees.
b) Some costs are not journalized during the accounting period
because they expire with the passage of time rather than through
recurring daily transactions. Examples are equipment deterioration,
and rent and insurance expiring.
c) Some items may be unrecorded. An example of a utility bill
that will not be received and/or paid until the next accounting period.
I. Types of Adjusting Entries—refer to handout, page 5 and Illustration 3-2
—Categories of adjusting entries on page 93 of the textbook where the text
breaks the categories into two sections as follows:
1. Prepayments:
a) Prepaid Expenses—expenses paid in cash and recorded as assets
(or expenses as shown in the chapter appendix—alternative treatment of
prepaid expenses) before they are used or consumed. Depreciation of
plant assets falls into this category.
b) Unearned Revenues—cash received and recorded as liabilities
(or revenues as shown in the chapter appendix—alternative treatment of
unearned revenues) before revenue is earned.
2. Accruals:
a) Accrued Revenues—revenues earned but not yet received in
cash or recorded.
b) Accrued Expenses—expenses incurred but not yet paid in cash
or recorded.

II. Accounting for Accrued Expenses (see section—ADJUSTING


ENTRIES FOR ACCRUALS—pages 103-107). The accrual of expenses

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creates liabilities as shown in Illustration 3-16 on page 105 of the text.
Expenses that have been incurred but not yet recorded at the end of an accounting
period require an adjusting entry to recognize both the proper amount of expense
for the period on the income statement and the proper amount of liabilities on the
balance sheet. Accrued Expenses are also called Accrued Liabilities because accrued
expenses have not been paid as of the end of the period and thus represent a liability
of the firm. Helpful hint to remember what is done with Accruals: The “A” in
Accrual means add to expense or revenue as the adjusting entry will be adding to
expenses or to revenues.

A. Explain ACCRUED SALARIES and the adjustment needed (see


textbook pages 106-107):
1. How accrued salaries occur—accrued salaries occur only when the last
day of the payroll period and the last day of the accounting period are
different days.
2. Steps to accrue salaries:
a. Determine the days to accrue: BE CAREFUL determining the
number of days to accrue salaries. Best way to determine the number of
days to accrue is to set up a calendar of the week and notate what day the
year ends. YOU ARE ACCRUING THE EXPENSE FOR THE
CURRENT YEAR (2008) NOT THE FOLLOWING YEAR (2009). If
$20,000 is the weekly payroll, the daily amount for a five-day work
week would be $4,000:
2008 2009
Dec. 29 30 31 Jan. 1 2
Monday Tuesday Wednesday Thursday Friday Total
$4,000 $4,000 $4,000 $4,000 $4,000 $20,000
$12,000 is Accrued $8,000 is NOT Accrued

b. Determine the amount to accrue: $20,000 is total payroll ÷ 5


days = $4,000 per day x 3 days (Dec. 29 – Dec. 31) = $12,000.
c. Prepare the adjusting entry:
General Journal Page 1
Date Account Title P.R. Debit Credit
2008 Adjusting Entries
Dec. 31 Salaries Expense 12,000.00
Salaries Payable 12,000.00

d. Post adjusting entry to the General Ledger—see Illustration 3-


20—Salary accounts after adjustment, page 106 of the text.

3. An adjusting entry, such as one for an accrued expense, affects both the
income statement and the balance sheet (shown on Illustration 3-16 on
page 105) as it results in an increase (debit) to an expense account and an
increase (credit) to a liability account. In the case of an accrued expense

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such as accrued salaries, the income statement is affected because an
expense account (Salaries Expense) is debited; a balance sheet account is
affected because a liability account (Salaries Payable) is credited (see page
106 of the textbook).

4. Affect if the adjusting entry for accrued expenses is OMITTED—refer


to the “ADJ-Accrued Expenses” entry on handout, page 16, chapter 3 of
the HANDOUT PACKET and bottom of page 106 of the textbook:
a. Expenses are understated as did not accrue the additional expense
of Salaries Expense. The first line on the handout is showing the balances
in the accounts if fail to do the adjustment. Expenses are showing a
balance of $50 but the balance SHOULD BE (S/B) $60 as an additional
expense of $10 should have been accrued. Therefore expenses are
understated by $10 if the adjusting entry is omitted.
b. Liabilities are understated as did not accrue the additional liability
owed of Salaries Payable. The first line on the handout is showing the
balances in the accounts if fail to do the adjustment. Liabilities are
showing a balance of $100 but the balance SHOULD BE (S/B) $110 as
an additional liability of $10 should have been accrued. Therefore
liabilities are understated by $10 if the adjusting entry is omitted.
c. Net income is overstated as did not accrue the additional expense
of Salaries Expense which would reduce the amount of net income as
expenses decrease income and owner’s equity. The first line on the
handout is showing a net income of $50 ($100 Revenues - $50 Expenses)
if fail to do the adjustment. When the accrued expense is made the net
income is $40 ($100 Revenues - $60 Expenses). Therefore net income is
overstated by $10 if the adjusting entry is omitted.
5. TYPICAL STUDENT MISCONCEPTION: Students often want to use
the Cash account when making an adjusting entry for an accrual. This
point needs to be emphasized—Cash is NEVER involved in ANY adjusting
entry. The reason is that the Cash account should already be reconciled
BEFORE adjusting entries are made. If an adjusting entry is made to the
Cash account, the account WILL NO LONGER BE RECONCILED to the
balance per the bank statement.

B. Explain accrued interest and the adjustment needed. Helpful hint to


remember what is done with Accruals: The “A” in Accrual means add to
expense or revenue as the adjusting entry will be adding to expenses or to
revenues. Thus with accrued interest, additional interest will be added to the
interest expense account.
1. How to calculate the due date of a note:

Determine Due Dates of Notes


(a) 90 days from May 8:
Begin with last day of month that the note was dated May 31

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Subtract the date of the note May -8

Days in the first month May 23


Add the total days in the following month June 30 84 days
Add the total days in the following month July 31
Due Date of
Days needed in the next month for a total of 90 days Aug 6 Note
Total days of note 90

2. How to calculate interest: Interest (I): The cost of borrowing money


that accumulates with the pages of time or the charge for credit; calculated
as principal (P) x rate (R) x time (T). Bankers’ interest uses a 360-day year
if the note is by days but if notes are by months as shown on the bottom of
page 101 of the text, then the denominator will use 12 for months in a year.
3. Accrued interest arises when the accounting period ends BEFORE THE
NOTE REACHES ITS MATURITY DATE. The interest from day of note
to the end of the accounting period is an expense and a liability and must
be recorded with an adjusting entry.
4. Steps to make an adjusting entry for accrued interest:
a. Determine the days from the date of the note to the end of the
accounting period. Refer to the example: Assume that on November
1, 2008, Bluff City Supply Company borrowed $12,000 on a 90-day,
14% note (the day after the note is signed is the first day when
counting days).
Begin with last day of month that the note was dated Nov. 30
Subtract the date of the note Nov. -1

Days in November Nov. 29


Add the total days in December Dec. 31
Total days from the date of the note to end of period 60
b. Calculate the interest from the date of the note to the end of the
accounting period.
Principal x Rate x Time = Interest
$12,000 X 14% X 60/360 = $280
c. Make the adjusting entry:
General Journal Page 1
Date Account Title P.R. Debit Credit
2008 Adjusting Entries
Dec. 31 Interest Expense 280.00
Interest Payable 280.00

d. Post to the General Ledger:


Owner's
Assets = Liabilities + + Rev. - Expenses
Equity
Cash Interest Payable Interest Expense
Dec.31 Adj. Dec. 31 Adj.

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280 280
5. Affect if the adjusting entry for accrued expenses is OMITTED—refer to
the “ADJ-Accrued Expenses” entry on handout, page 16, chapter 3 of the
HANDOUT PACKET and page 105 of the textbook:
a. Expenses are understated as did not accrue the additional
expense of Interest Expense. The first line on the handout is showing the
balances in the accounts if fail to do the adjustment. Expenses are
showing a balance of $50 but the balance SHOULD BE (S/B) $60 as an
additional expense of $10 should have been accrued. Therefore expenses
are understated by $10 if the adjusting entry is omitted.
b. Liabilities are understated as did not accrue the additional
liability owed of Interest Payable. The first line on the handout is showing
the balances in the accounts if fail to do the adjustment. Liabilities are
showing a balance of $100 but the balance SHOULD BE (S/B) $110 as
an additional liability of $10 should have been accrued. Therefore
liabilities are understated by $10 if the adjusting entry is omitted.
c. Net income is overstated as did not accrue the additional
expense of Interest Expense which would reduce the amount of net
income as expenses decrease income and owner’s equity. The first line on
the handout is showing a net income of $50 ($100 Revenues - $50
Expenses) if fail to do the adjustment. When the accrued expense is
made the net income is $40 ($100 Revenues - $60 Expenses). Therefore
net income is overstated by $10 if the adjusting entry is omitted.
C. Describe other types of accrued expenses—the adjusting entry always
involves a debit to an expense and a credit to a liability.
1. To accrue rent that is owed but unpaid at the end of the accounting
period—debit Rent Expense and credit Rent Payable.
2. To accrue taxes that are owed but unpaid at the end of the accounting
period—debit Taxes Expense and credit Taxes Payable.
3. To accrue utilities that are owed but unpaid at the end of the
accounting period—debit Utilities Expense and credit Utilities Payable.
NOTE that the liability account used matches the expense account.
Accounts Payable could be used rather than Utilities Payable. See
ACCRUALS and Expenses, on handout, page 15, chapter 3 of the
HANDOUT PACKET. The example where a bill is received and paid
the next period shows that some expense will be debited and accounts
payable is credited. But since for the CB exam, the LIABILITY matches
the EXPENSE, they are done here as well.

III. Accounting for Accrued Revenue (see section—ADJUSTING


ENTRIES FOR ACCRUALS—pages 103-104). The accrual of revenue
creates assets as shown on pages 103-104 of the textbook. Accrued revenue has
been earned in the current accounting period but the cash will NOT BE
RECEIVED until the next period. Accrued revenue is also called an Accrued Asset
as the debit will be to a Receivable (an asset) account when accrued revenue is

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credited (see Illustration 3-11—Adjusting Entries for accrued revenues). Helpful hint
to remember what is done with Accruals: The “A” in Accrual means add to expense or
revenue as the adjusting entry will be adding to expenses or to revenues in this case.
Remember that the goal is to adhere to the revenue recognition principle—a business
earns (realizes) revenue when goods or services are sold to customers, even though
cash may not be collected until sometime in the future. Therefore, to make sure that the
correct amount of revenue is shown that is earned each fiscal year for the accrual basis
of accounting, some revenue may need to be accrued that has been earned but not yet
recorded. Adjusting entries to accrue revenue will affect both an income statement
(credit to a revenue) and a balance sheet (debit to a receivable) account (refer to the
top line on handout, page 15 and the comment at the bottom of handout, page 5,
chapter 3 of the HANDOUT PACKET—ALL adjusting entries effect one Income
Statement account and one Balance Sheet account.
A. Explain accrued rent revenue and the adjustment needed.
1. Accrued rent revenue—revenue earned but not yet received.
2. Steps to prepare the adjusting entry:
a. Calculate the amount of rent earned.
b. Prepare the adjusting entry—an adjusting entry for accrued
revenues results in an increase (debit) to an asset account and an
increase (credit) to a revenue:
General Journal Page 1
Date Account Title P.R. Debit Credit
2008 Adjusting Entries
Dec. 31 Rent Receivable 1,200.00
Rent Income 1,200.00
c. Post to the General Ledger where the Rent Receivable will be
shown under the current asset section on the Balance Sheet and Rent
Income account will be closed and its balance listed as nonoperating
revenue on the income statement:
Owner's
Assets = Liabilities + + Revenues - Expenses
Equity
Cash Rent Income
Dec.31 Adj.
1,200
Rent Receivable
Dec.31 Adj.
1,200

3. A good way to understand the concept of accrued revenue is the


mirror image concept—accrued revenue is the mirror image of accrued
expenses. A rent accrual can be shown as follows:
a. From the Lessor perspective, the entry would be:
Debit—Rent Receivable 1,200
Credit—Rent Income 1,200
b. From the Lessee perspective, the entry would be:

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Debit—Rent Expense 1,200
Credit—Rent Payable 1,200
4. Affect if the adjusting entry for accrued revenues is OMITTED—refer
to the “ADJ-Accrued Revenues,” on handout, page 16 chapter 3 of the
HANDOUT PACKET and page 104 of the textbook:
a. Revenues are understated as did not accrue the additional revenue
of Rent Income. The first line on the handout is showing the balances in
the accounts if fail to do the adjustment. Revenues are showing a
balance of $100 but the balance SHOULD BE (S/B) $110 as an additional
revenue of $10 should have been accrued. Therefore revenues are
understated by $10 if the adjusting entry is omitted.
b. Assets are understated as did not accrue the additional receivable
owed to the company of Rent Receivable. The first line on the handout is
showing the balances in the accounts if fail to do the adjustment.
Assets are showing a balance of $200 but the balance SHOULD BE (S/B)
$210 as an additional receivable of $10 should have been accrued.
Therefore assets are understated by $10 if the adjusting entry is omitted.
c. Net income is understated as did not accrue the additional revenue
of Rent Income which would increase the amount of net income as
revenues increase income and owner’s equity. The first line on the
handout is showing a net income of $50 ($100 Revenues - $50 Expenses)
if fail to do the adjustment. When the accrued revenue is made the net
income is $60 ($110 Revenues - $50 Expenses). Therefore net income is
understated by $10 if the adjusting entry is omitted.
B. Describe other types of Accrued Revenue:
1. In Chapter 9 Notes Receivable are covered and should be considered
as the mirror image of Notes Payable. Calculations of due date and interest
are identical for notes payable and notes receivable and where one company’s
interest expense is another company’s interest income. To accrue interest
income:
a. Calculate interest earned from the date of the note until the
end of the accounting period—P x R x T.
b. Record the adjusting entry:
Debit—Interest Receivable
Credit—Interest Income
2. Any unbilled revenues such as fees earned or sales made but where
the cash has not yet been received needs to be accrued to accounts
receivable. Normally the name of the receivable account will match the
name of the revenue account as shown in the above examples (i.e. Rent
Receivable/Rent Income; Interest Receivable/Interest Income, etc.) unless
the revenue is for the regular income for the business (see example for
Pioneer Advertising Agency—page 104). See section 4 Accrued Revenues
on handout, page 16, chapter 3 of the HANDOUT PACKET. With the
example of fees earned, but not yet recorded with the example shown:
Debit—Accounts Receivable
Credit—Fees Earned

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IV. Summary of Accruals—refer to handout, page 4 (3-19)—ILLUSTRATION
3-4: ACCRUAL RELATIONSHIPS” section 3:
A. Accruals ALWAYS Add—the “A” in accrual means Add. You always Add
to expense or Add to revenue (bringing in something not yet recorded into
the present) and you ALWAYS Add to the Balance Sheet (liabilities or assets
and Add to the Income Statement (expenses or revenues).
B. The adjustment for accruals usually (unless you are accruing the service or
sales revenue for the normal operations of the business in which case
accounts receivable is the account) ALWAYS creates a balance sheet account.
C. Accruals can ALWAYS be reversed (see APPENDIX, chapter 4 of the
textbook: Reversing Entries—pages 169-171). This point is a key one before
going on to deferrals, which can only SOMETIMES BE REVERSED. The
RULE TO MASTER: Whenever an adjusting entry creates a Balance Sheet
account (liability or asset) reversal is possible and desirable as well so that the
adjusting entry into the created account WILL NOT BE FORGOTTEN. As
shown on page 107, when the salaries are paid on November 9, the debit to
Salaries Payable must be made along with the amount for Salaries Expense.
But the amount in Salaries Payable is often FORGOTTEN and the entire
amount of $4,000 in this example is debited to Salaries Expense.
Refer to HOMEWORK PROBLEM BE3-7 to prepare accrued adjusting entries:
Date Account Name Debit Credit
Dec. 31 Interest Expense 400
Interest Payable ?

31 Accounts Receivable ?
Service Revenue 1,500

31 Salaries ? ?
Salaries Payable ?

V. Accounting for Prepayments: Prepaid (Deferred) Expenses. Deferred


expenses are also called prepaid expenses or deferred charges. A key
letter, “D” and a key word, “Deduct,” to remember with Deferrals as
amounts are deducted from deferrals during the adjusting process to
record correct expenses incurred and revenues earned. With deferred
expenses and deferred revenues, not all adjusting entries can be
reversed as can be done with accrued expenses and accrued revenues.

A. Explain the entries needed when deferred expenses are first recorded as assets.
1. Define deferred expense—advance payment for goods or services that
benefit more than one accounting period. Deferred expenses are actually
Prepaid expenses (supplies, prepaid insurance, prepaid rent, prepaid
advertising, etc.). Deferred expenses have already been paid, but will

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benefit future periods. To match (Matching principle) revenue and
expenses properly, a part of the deferred expense must be “put off” into
the future (part that has future benefit) and part must be recognized in the
current period (part that has been used or expired). Be Careful with the
word, “Expense,” as many students get confused thinking that the
account must be an Expense account but the usual transaction is to
record the amounts paid for expenses paid in advance as an asset NOT
AN EXPENSE. If the prepayment will become an expense in one year or
less, then the prepaid expense account is listed under the “Current
Asset” section of the Balance Sheet. If the prepayment will become an
expense longer than one year, it is shown in the “Other Asset” section
(long-term section) of the Balance Sheet as a Deferred charge.

2. To differentiate between Accruals and Deferrals, think of the phrase:


“Show me the money!” Refer to handout, page 15, chapter 3 of the
HANDOUT PACKET—DEFERRALS vs. ACCRUALS.
a. NOTE with Deferrals, money has changed hands—under 1.
Expenses, “Pd. $, but not yet incurred exp.,” meaning that the money
has been paid in advance BEFORE an expense has been incurred.
Under 2. Revenues, “Received the $, but not yet earned it,” meaning
the money was received BEFORE a revenue has been earned.
b. NOTE with Accruals, money has NOT changed hands—under
3. Expenses, “Incurred exp., but not yet paid the $,” meaning that the
expense has not yet been paid by the end of the accounting period but
it HAS BEEN INCURRED. Under 4. Revenues, “Earned, but not yet
received the $,” meaning revenues HAVE BEEN EARNED but the
money has not yet been received at the end of the accounting period.

3. When deferred or prepaid expenses are initially recorded as


assets, an adjusting entry is needed to transfer the amount of the
asset used or expired from the asset account to an expense account.
Refer to handout (FIGURE 17-1 Transaction: Prepaid a one-year
insurance policy for $3,600, page 13, chapter 3 of the HANDOUT
PACKET—Comparison of Methods for Recording Prepaid
Expenses—and the first column, “Recorded as Asset:”
a. The first box shows the initial recording when the cash was
paid. On October 1, an entry for $3,600 for a one-year insurance
policy.
b. The second box shows the adjusting entry that transfers the
amount of expenditure (for insurance in the example) expired or used
to an expense account. To calculate the amount expired, divide the
amount by 12 (months in a year) and then multiply by the number of
months that have expired as follows: $3,600 ÷ 12 = $300/month x 3
months = $900 expired.

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c. The third box shows the closing entry that closes the balance of
the expense account to the income summary which then becomes part
of owner’s equity for the net income or net loss of the company.
d. The fourth box addresses the concept of whether a reversing
entry will be considered or not (Reversing entries are introduced in
the Appendix, chapter 4 of the textbook). NOTE that no reversing
entry will be made. Recall the RULE TO MASTER: Whenever an
adjusting entry creates a Balance Sheet account (liability or asset)
reversal is possible. When a deferred or prepaid expense is initially
recorded as an asset, the adjusting process will create an expense
account that is closed in the normal closing routine at the end of the
fiscal year. Since NO ASSET or LIABILITY account was created
during the adjustment, there is no support for a reversing entry.

4. Describe the adjustment for supplies used. The supplies account


will contain the amount that was in the account at the beginning of the
period plus (+) any supplies purchased during the period Pioneer
Advertising Agency, on page 97, purchased advertising supplies costing
$2,500 on October 5. A debit (increase) was made to the asset
Advertising Supplies. This account shows a balance of $2,500 on the
October 31 trial balance (T.B.). The adjustment will be the amount of
supplies that have been USED. At October 31st, an inventory of supplies
is taken and it is determined that $1,000 of supplies is still on hand. In
order to determine the amount of supplies used, you must SUBTRACT.
THIS STEP IS OFTEN FORGOTTEN and should be done as follows:
Balance of account on T.B. 2,500.00
- Inventory count (amount on hand) - 1,000.00
= Amount USED (the adjustment) 1,500.00
Assets = Liabilities + Owner’s Equity + Revenues - Expenses
Adver. Supplies Adver. Supplies Exp.
2,500 1,500 USED 1,500
1,000
Note that after the adjusting entry, the balance of the Advertising Supplies account,
$1,000 reflects the amount shown in the inventory count or the amount of the
supplies still on hand. Every adjusting entry affects both the balance sheet and the
income statement. For example, the adjustment for supplies used, the debit is to
Supplies Expense (an income statement account) and the credit is to supplies (a
balance sheet account). This will always hold true.
5. Illustrate the adjustment needed for depreciation of assets.
a. Define depreciation—an allocation process in which the cost of a long-
term asset (except land as land is considered permanent and is assumed
to last forever, so depreciation is not allowed) is divided over the
periods in which the asset is used (useful life) in the production of the
business’s revenue in a rational and systematic manner. The objective of
depreciation accounting is to spread the cost of a long-term asset over

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the assets’ useful life, rather than treating the cost of an asset as an
expense in the year of purchase. TYPICAL STUDENT
MISCONCEPTION: in accounting for depreciation, students often
think of depreciation in the economic sense. That is, they view it as a
valuation process used to record the decline in the value of an asset. In
accounting, depreciation has nothing to do with value. It refers only
to the allocation of an asset’s cost over its estimated useful life. As time
passes, the usefulness of assets will decline, and eventually they will no
longer serve their original purpose so the accounting system, must,
therefore, reflect the fact that the equipment and furniture will
gradually wear out or become obsolete and will have to be replaced.
b. Describe the straight-line method of computing depreciation—
a popular method of calculating depreciation that yields the same
amount of depreciation for each full period an asset is used. When
calculating the amount of the adjustment for straight-line depreciation,
you should always calculate a yearly amount first, then a monthly
amount. See example on page 99 of the textbook.
c. Describe the contra-account Accumulated Depreciation. The
depreciation adjustment is not reflected directly in the asset account.
Accumulated Depreciation is a contra asset account—an account
whose balance is opposite (offset against) the asset to which it relates.
Since asset accounts have debit balances, contra asset accounts (the
opposite of assets) have credit balances. Contra means opposite or
against like in the words contradiction, contraband, and contrary
(similar to what drawing and expenses do to owner’s equity).
Depreciation is recorded in the Accumulated Depreciation account ,
rather than directly in the asset account, so as to maintain both the
asset account showing the original (or historical) cost of the asset
and the Accumulated Depreciation account showing how much the
asset has depreciated (the total cost that has expired to date). This is
especially needed when the asset is sold to determine any gain or loss
on the sale of the asset. The questions that must be answered on the
tax return are:
1. What was the original cost of the asset? (the amount is
found in the asset account)
2. What is the total depreciation that has been taken on
the asset? (the amount is found in the accumulated
depreciation account)
3. How much was the asset sold for?
4. What is the gain or loss on sale?
The use of a contra account provides disclosure of both the
original cost of the equipment and the total cost that has expired
to date.
Refer to the example of the allocation process for the purchase of a truck over the
truck’s useful life and the calculation of book value (explained below) on the
handout, page 2 (3-17)—ILLUSTRATION 3-2: DEPRECIATION.

13
The following example illustrates the process of allocating expired (deferred)
prepayments to expenses:
Assets = Liabilities + Owner’s Equity + Revenues - Expenses
Office Supplies Office Supplies Exp.
125 45 USED 45
150
275
230
Prepaid Insur. Insurance Expense
240 20 USED (EXPIRED) 20
220
Office Equip.
3,000
Acc.Dep-Off Eq USED (ALLOCATED) Depr.Exp.-Off. Eq.
50 50
Office Furn.
2,000
Acc.Dep-Off Furn Depr.Exp.-Off.Furn.
USED (ALLOCATED)
30 30
d. Every adjusting entry affects both the balance sheet and the income
statement. For example, the adjustment for depreciation, the debit is to
Depreciation Expense (an income statement account) and the credit is to
accumulated depreciation (a balance sheet account).

e. Book Value of an asset. Refer to Illustration 3-8 on page 100 of the


text showing the partial balance sheet. Note how the balance sheet
discloses the book value of each asset—the difference between an
asset’s cost and its accumulated depreciation. The book value of an
asset and its market value are not the same. The book value is just the
value that is being shown “on the books,” also sometimes referred to
as carrying value or unexpired cost. Book value is cost minus (-)
accumulated depreciation; market value is what the asset would sell
for. A question that often comes up is: Can a business continue to use
an asset if it has been fully depreciated (book value is equal to zero).
The answer is, YES, because the purpose of depreciation accounting is
to spread the cost of an asset over its useful life. An asset may last
longer than its “estimated” useful life

Refer to HOMEWORK PROBLEM BE3-4 to prepare the adjusting entry for


depreciation, post to a T account, and indicate the balance sheet presentation:
Date Account Name Debit Credit
Adjusting Entries
Dec 31 Deprec. Exp.--Equipment ?
Accum. Depr.--Equip. 5,000

14
DPR Expense- Equipment Accum. DPR- Equipment
5,000 ?
Balance Sheet
Equipment 30,000
Less: Accumulated depreciation ? 25,000

6. Affect if the adjusting entry for deferred expenses, initially recorded as


assets, is OMITTED—refer to the “ADJ-Deferred Expenses” entry on
handout, page 16, chapter 3 of the HANDOUT PACKET and page
97 of the textbook:
a. Expenses are understated as did not accrue the additional expense
of Insurance or Supplies Expense. The first line on the handout is
showing the balances in the accounts if fail to do the adjustment.
Expenses are showing a balance of $50 but the balance SHOULD BE
(S/B) $60 as an additional expense of $10 should have recorded.
Therefore expenses are understated by $10 if the adjusting entry is
omitted.
b. Assets are overstated as did not adjust the asset for the portion
used or expired. The first line on the handout is showing the balances
in the accounts if fail to do the adjustment. Assets are showing a
balance of $200 but the balance SHOULD BE (S/B) $190 as an asset
should have been reduced by $10 for the portion used or expired.
Therefore assets are overstated by $10 if the adjusting entry is
omitted.
c. Net income is overstated as did not record the additional expense
of Insurance or Supplies Expense which would reduce the amount of
net income as expenses decrease income and owner’s equity. The first
line on the handout is showing a net income of $50 ($100 Revenues -
$50 Expenses) if fail to do the adjustment. When the additional
expense is recorded the net income is $40 ($100 Revenues - $60
Expenses). Therefore net income is overstated by $10 if the adjusting
entry is omitted.

7. Explain the entries needed when deferred expenses are first recorded as
expenses. (See APPENDIX Alternative Treatment of Prepaid Expenses
and Unearned Revenues—pages 115-118 and pages 10-11 handouts
(ILLUSTRATION 3-9—PREPAYMENTS—ALTERNATIVE
TREATMENT and ILLUSTRATION 3-2—ALTERNATIVE
TREATMENTS OF PREPAID EXPENSES AND UNEARNED
REVENUE). End-of-the-year adjustments are different for the two
methods. Refer to handout, page 13, chapter 3, FIGURE 17-1 of the
HANDOUT PACKET—Comparison of Methods for Recording
Prepaid Expenses—and the second column, “Recorded as Expense:”
a. The first box shows the initial recording when the cash was
paid. There are two ways to initially record deferred or prepaid
expenses (1) as assets or (2) as expenses. Both methods yield the

15
identical results on the income statement and the balance sheet. A
question usually arises at this point as to WHY would this entry be
initially recorded as an EXPENSE and believe it or not, from an
auditor’s perspective, this is the METHOD that I have observed is
the MORE COMMON method done in practice. Some of the
reasons are:
i. The entry was made by an inexperienced or not
properly educated bookkeeper who believes that any time an
expenditure is made; IT MUST BE AN EXPENSE because
money has been spent and anytime money is spent, it is an
expense with that thinking.
ii. There is actually a conceptual reason for recording this
type of expenditure initially as an expense especially dealing
with the expenditure for supplies. If it is believed that all of
the supplies would be used by the end of the accounting period,
then it would be wise to initially record the amount as an
expense because then it would not be necessary to make an
adjusting entry at the end of the accounting period. This
reasoning does not make sense, though, when paying for an
insurance policy because you would know at the time of the
payment if the policy would totally expire or not by the end of
the accounting period. But if most of the policy will be
expired, then it could be initially recorded as an expense.
b. The second box shows the adjusting entry that transfers the
amount of the expenditure that is unexpired (insurance in the
example) to an asset account.
c. The third box shows the closing entry that closes the balance of
the expense account to the income summary which then becomes
part of owner’s equity for the net income or net loss of the
company.
d. The fourth box addresses the concept of whether a reversing
entry will be considered or not. . Recall the RULE TO MASTER:
Whenever an adjusting entry creates a Balance Sheet account
(liability or asset) reversal is possible and desirable as well so that
the adjusting entry into the created account WILL NOT BE
FORGOTTEN. Since an asset account had been created in the
adjusting process (prepaid insurance in the example), a reversing
entry is needed to return the prepayment to an expense in the next
accounting period.

VI. Accounting for Prepayments: Unearned (Deferred) Revenues.


Deferred revenue can also be called unearned revenue or deferred
credits. End-of-the-year adjustments are different for the two methods.
A key letter, “D” and a key word, “Deduct,” to remember with
Deferrals as amounts are deducted from deferrals during the

16
adjusting process to record correct expenses incurred and revenues
earned. With deferred expenses and deferred revenues, not all
adjusting entries can be reversed as can be done with accrued
expenses and accrued revenues. Another liability called unearned
(deferred) revenue that does not have the word, "payable," with the name of the
account but it is a liability (a debt owed by the company) as it originates from
receiving cash in advance before a revenue (income earned from carrying out the
activities of a firm) is performed. The reason that this account is a liability is
that a service or sale must be made requiring a performance in the future (a
liability as a debt of performance is owed) or the money must be refunded (a
liability as a debt owed) if the job is not done.

A. Explain the entries needed when deferred revenue is first recorded


as a liability—refer to handout, page 14—FIGURE 17-2: Comparison
of methods for recording deferred revenue:
1. The first box shows the initial recording when the cash was
received.
2. The second box shows the adjusting entry that transfers the
amount of money received (for subscriptions in the example) in advance
that has been earned to a revenue account.
3. The third box shows the closing entry that closes the balance of the
revenue account to the income summary which then becomes part of
owner’s equity for the net income or net loss of the company. (Closing
entries are covered in chapter 4 of the textbook).
4. The fourth box addresses the concept of whether a reversing entry
will be considered or not. NOTE that no reversing entry will be made.
Recall the RULE TO MASTER: Whenever an adjusting entry creates a
Balance Sheet account (liability or asset) reversal is possible. When
deferred or unearned revenue is initially recorded as a liability, the
adjusting process will create or increase a revenue account that is closed
in the normal closing routine at the end of the fiscal year. Since NO
ASSET or LIABILITY account was created during the adjustment,
there is no support for a reversing entry.
5. Refer to the first column, handout, page 12, of the handout packet
under the section UNEARNED REVENUES showing an example of
the first approach where unearned revenue is initially recorded as a
liability.

6. Affect if the adjusting entry for deferred expenses, initially recorded


as assets, is OMITTED—refer to the “ADJ-Deferred Revenues” entry
on handout, page 16, chapter 3 of the HANDOUT PACKET and
page 101 of the textbook:
a. Revenues are understated as did not record the additional
revenue earned. The first line on the handout is showing the balances in
the accounts if fail to do the adjustment. Revenues are showing a

17
balance of $100 but the balance SHOULD BE (S/B) $110 as additional
revenue of $10 should have been recorded. Therefore revenues are
understated by $10 if the adjusting entry is omitted.
b. Liabilities are overstated as did not adjust the portion of the
unearned revenue that has now been earned and should be transferred to
a revenue account. The first line on the handout is showing the balances
in the accounts if fail to do the adjustment. Liabilities are showing a
balance of $100 but the balance SHOULD BE (S/B) $90 as a liability
should have been reduced by $10 for the portion earned. Therefore
liabilities are overstated by $10 if the adjusting entry is omitted.
c. Net income is understated as did not record the additional
revenue that had been earned where revenues increase income and
owner’s equity. The first line on the handout is showing a net income of
$50 ($100 Revenues - $50 Expenses) if fail to do the adjustment.
When the additional revenue is recorded the net income is $60 ($110
Revenues - $50 Expenses). Therefore net income is understated by
$10 if the adjusting entry in omitted.

B. Explain the entries needed when deferred revenue is first recorded


as revenue. . (See APPENDIX Alternative Treatment of Prepaid Expenses
and Unearned Revenues—pages 115-118 and page 11 handout
(ILLUSTRATION 3-2—ALTERNATIVE TREATMENTS OF PREPAID
EXPENSES AND UNEARNED REVENUE). End-of-the-year adjustments
are different for the two methods. Refer to handout, page 14—FIGURE 17-
2, chapter 3 of the HANDOUT PACKET—Comparison of Methods
for Recording Deferred Revenue—and the second column, “Recorded as
Revenue:”
1. The first box shows the initial recording when the cash was
received. There are two ways to initially record deferred or unearned
revenues (1) as liabilities or (2) as revenues. Both methods yield the
identical results on the income statement and the balance sheet. A
question usually arises at this point as to WHY would this entry be
initially recorded as an REVENUE and believe it or not, from an
auditor’s perspective, this is the METHOD that I have observed is the
MORE COMMON method done in practice. Some of the reasons are:
a. The entry was made by an inexperienced or not properly
educated bookkeeper who believes that any time cash is deposited; IT
MUST BE REVENUE because money has been RECEIVED and
anytime money is RECEIVED, it is revenue with that thinking.
b. There is actually a conceptual reason for recording this
type of expenditure initially as revenue. If it is believed that all of the
revenue will be earned by the end of the accounting period, then it
would be wise to initially record the amount as revenue because then
it would not be necessary to make an adjusting entry at the end of the
accounting period. This reasoning does not make sense, though, when
receiving cash for subscriptions because you would know at the time

18
when the cash is received whether all the subscriptions will be sent or
not by the end of the accounting period. But if most of the
subscriptions will be sent, then it could be initially recorded as
revenue since the interim financial statements would be showing
closer to revenue that will be or has been earned.
2. The second box shows the adjusting entry that transfers the
revenues unearned (unearned subscriptions in the example) to a
liability account.
3. The third box shows the closing entry that closes the balance of the
revenue account to the income summary which then becomes part of
owner’s equity for the net income or net loss of the company. (Closing
entries are covered in chapter 4 of the textbook).
4. The fourth box addresses the concept of whether a reversing entry
will be considered or not. Recall the RULE TO MASTER: Whenever an
adjusting entry creates a Balance Sheet account (liability or asset)
reversal is possible and desirable as well so that the adjusting entry into
the created account WILL NOT BE FORGOTTEN. When a deferred or
unearned revenue is initially recorded as revenue, the adjusting process
will create or increase a liability account (some unearned revenue
account—unearned subscriptions income in the example) and since a
liability account had been created or increased in the adjusting process,
a reversing entry is needed to return the prepayment to revenue in the
next accounting period.

VII. Summary of Deferrals.

A. Deferrals always result in a DEDUCTION. You will always be reducing


what already happened. The final amount of expense or revenue that is shown
in the expense or revenue account will always be less than the dollar value that
you started to work with.

B. As explained and shown in handouts, page 5 and pages 10-14, chapter 3 of


the HANDOUT PACKET, there are always two methods to account for
deferrals. However, though there are two ways of recording deferrals, there
is still just ONE CORRECT RESULT.

Refer to HOMEWORK EXERCISE E3-17 to prepare the adjusting entries and


determine the balance in accounts:
Account Titles and
Date Explanations Ref. Debit Credit
Jan. 2 Insurance Expense ?
Cash 1,800

10 Supplies Expense 1,700


? ?

15 ? ?

19
Service Revenue 6,100
Insurance Expense
1/2 1,800

Cash
1/15 ? 1,800 1/2
1,700 1 /10

Supplies Expense
1/10 ?

Service Revenue
? /15
Adjusting Entries
Jan. 31 Prepaid ? ($150 x 11 months) ?
Insurance Expense ?

31 ? ?
Supplies Expense 800

31 Service ? (Hint:6100-2500)
Unearned Revenue ?
Prepaid Insurance
1/31 ?
Insurance Expense
1/2 ? ? 1/31
Bal. 150
Supplies
1/31 ?
Supplies Expense
1/10 ? ? 1/31
Bal. 900
Unearned Revenue
? 1/31
Service Revenue
1/31 ? ? 1/15
2,500 Bal.
Insurance expense 150
Supplies expense ?
Service revenue 2,500
Prepaid insurance ?
Supplies 800
Unearned revenue ?

VIII. Summary of Adjusting Entries.


A. Refer to handout, page 5—TYPES OF ADJUSTING ENTRIES and note:
1. The first column shows the adjusting entries separated into 5
types.
2. The second column explains the reasons for the adjustments.

20
3. The third column shows the account balances before adjustment.
4. The fourth column gives the general type of adjusting entry that
needs to be made.
B. Refer to handout, page 6—Explanation which explains the types of adjusting
entries as the textbook categorizes adjusting entries into four types as shown
in Illustration 3-9, p.100; Illustration 3-12, p.101; Illustration 3-15, p. 104;
and Illustration 3-21, p. 107 of the text.
C. Refer to handout, page 7 (3-21)—ILLUSTRATION 3-6: EXAMPLES OF
ADJUSTING ENTRIES to complete the practice exercise there and compare
your answers to the answers shown on the bottom of the handout.
D. Refer to handout, page 8 (3-22)—ILLUSTRATION 3-7: POSTING OF
ADJUSTING ENTRIES and review the adjusting entries in the example,
how they are posted to the appropriate accounts, and then how the final
balances in the accounts are determined after they have been posted.

Refer to HOMEWORK EXERCISE E3-8 to prepare the adjusting entries:


Date Account Titles and Explanations Ref. Debit Credit
Adjusting Entries
Jan. 31 Accts. ? 875
Service Revenue ?

31 Utilities ? ?
Utilities ? 520

31 Depreciation ? ?
Accum. ?--Dental ? 400

31 Interest ? ?
Interest ? ?

31 Insurance ? ($12,000 ÷ 12) ?


Prepaid Insurance ?

31 Supplies ? ($1,600 - $400) ?


Supplies ?
Refer to HOMEWORK EXERCISE E3-9 to prepare the adjusting entries:
Date Account Titles and Explanations Ref. Debit Credit
Adjusting Entries
Oct. 31 Advertising Supplies ? ?
Advertising Supplies ?
($2,500 - $500)

31 Insurance ? ?
Prepaid ? 100

31 Depreciation ? ?
? Deprec.--Office ? ?

31 Unearned Revenue 600

21
Service ? ?

31 ? Receivable ?
? Revenue 300

31 ? Expense ?
? Payable ?

31 Salaries ? ?
Salaries ? 1,500

IX. Accounting Records Formats for Adjusting Entries.


A. General Journal—refer to Illustration 3-19, page 108 of the textbook—
General Journal showing adjusting entries:
1. Note the caption, “Adjusting Entries,” that is entered on the first
line opposite the year of the adjusting entries. This caption helps to
inform the readers of the general journal that the entries that are
following are the adjusting entries—entries made at the end of an
accounting period to insure that the revenue recognition and the
matching principles are followed which bring the account balances up-to-
date.
2. Note that the entries in this illustration also have explanations as
well. The explanations are OPTIONAL if you use the caption at the
beginning of the adjusting entries, “Adjusting Entries,” as this is all that
is needed to inform the readers that the entries following are the
adjusting entries at the end of the accounting period.
B. General Ledger—refer to Illustration 3-23, page 109 of the textbook—
General Ledger after adjustment:
1. Note the adjusting entries are highlighted in red and also note the
words entered into the Explanation column which can be abbreviated as
shown, “Adj. entry,” which again alerts the readers of the general ledger
that these entries were made at the end of the accounting period to bring
the balances of the accounts up-to-date.
2. Note the date transferred from the general journal shows that the
entries were made the last day of the accounting period.
C. Preparing the Adjusted Trial Balance—refer to Illustration 3-24, page
110 of the textbook—Adjusted trial balance:
1. It proves the equality of the total debit balances and the total
credit balances in the ledger after all the adjustments have been made.
2. The accounts in the adjusted trial balance contain all the data that
are needed for the preparation of the financial statements except for the
capital account that may have additional investments in which case that
information would show in the general ledger account.
Refer to HOMEWORK PROBLEM P3-1 to prepare the adjusting entries, post
to the ledger, and prepare an adjusted trial balance: J3
2008 Adjusting Entries

22
June 30 Supplies ? 631 ?
Supplies 126 ?
($2,000 - $600)

30 Utilities ? 732 ?
Utilities ? 244 150

30 Insurance ? 722 ?
Prepaid ? 130 ?
$3,000 ÷ 12 months)

30 Unearned ?Rev. 209 ?


Service Revenue 400 ?

30 Salaries ? 726 ?
Salaries ? 212 ?

30 ?Expense 711 ?
Accum.?--Office Equip. 158 ?
($15,000 ÷ 60 months)

30 Accounts ? 112 ?
Service ? 400 1,000
Following is the partial General Ledger to follow these examples:
GENERAL LEDGER
Cash No. 101
Date Explanation Ref Debit Credit Balance
2008
June 30 Balance √ 7,150

Accounts Receivable No. 112


Date Explanation Ref Debit Credit Balance
2008
June 30 Balance √ 6,000
30 Adjusting J3 1,000 7,000

Supplies No. 126


Date Explanation Ref Debit Credit Balance
2008
June 30 Balance √ 2,000
30 Adjusting J3 1,400 600

23
Prepaid Insurance No. 130
Date Explanation Ref Debit Credit Balance
2008
June 30 Balance √ 3,000
30 Adjusting J3 250 2,750
Office Equipment No. 157
Date Explanation Ref Debit Credit Balance
2008
Balance
June 30 √ 15,000
Accum. Depr- Office Equipment No. 158
Date Explanation Ref Debit Credit Balance
2008
June 30 Adjusting J3 250 250

Accounts Payable No. 201


Date Explanation Ref Debit Credit Balance
2008
June 30 Balance √ 4,500
Following is the trial balance:
MASASI COMPANY
Adjusted Trial Balance
June 30, 2008
Debit Credit
Cash $ 7,150
Accounts Receivable ?
Supplies ?
Prepaid Insurance ?
Office Equipment ?
Accum. Depr.- Office Equipment $ 250
Accounts Payable ?
Utilities Payable ?
Salaries Payable ?
Unearned Service Revenue 1,500
T. Masasi, Capital ?
Service Revenue 11,400
Supplies Expense 1,400
Depreciation Expense ?
Insurance Expense ?
Salaries Expense ?
Rent Expense ?
Utilities Expense ?
$ 41,550 $ 41,550
D. Preparing Financial Statements—refer to Illustrations 3-25 and 3-26,
pages 111-112 of the textbook:

24
1. The income statement is the first prepared from the revenue and
expense accounts where the numbers are entered from the adjusted trial
balance with the adjusted account balances.
2. The owner’s equity statement is derived from the owner’s capital
and drawing accounts and the net income (loss) from the income
statement.
3. The balance sheet is then prepared from the asset and liability
accounts and the ending owner’s capital from the owner’s equity
statement.
Refer to HOMEWORK PROBLEM BE3-9 to prepare an income statement:
HARMONY COMPANY
Income Statement
For the Year Ended ? 31, 2008
Revenues:
Service revenue $?
Expenses:
? expense $16,000
Rent ? ?
?? 2,000
? expense ?
? expense ?
Total expenses ?
Net income $10,600
Refer to HOMEWORK EXERCISE E3-10 to prepare an income statement:
BENNING CO.
Income Statement
For the Month Ended July 31, 2008

Revenues:
Service revenue ($5,500 + $500) $?
Expenses:
Wages ? ($2,300 + $300) $?
? expense ($1,200 - $200) ?
Utilities ? ?
? expense 400
? expense ?
Total expenses 4,750
Net income $?
Refer to HOMEWORK PROBLEM BE3-10 to prepare an owner’s equity
statement:
HARMONY ?
Owner's Equity ?
For the ? Ended December 31, ?
S. Harmony, capital, January 1 $15,600
Add: Net income ?
?
Less: Drawings 6,000
S. Harmony, capital, December 31 $?

25
Refer to HOMEWORK PROBLEM P3-3A that requires preparation of adjusting
entries, financial statements, and to determine the months of a note outstanding.
Below are partial financial statements with check figures to check the accuracy of
your adjusting entries and some help with the time of the note:
FERNETTI ADVERTISING AGENCY
Income Statement
For the Year Ended December 31, 2008
Revenues:
Advertising revenue (Hint $62,700 Cr.-$58,600 Cr.= $4100: Cr. Rev.; Dr. A/R, 2500 + Dr.
Unearn. Rev.; Cr. Rev., 1600)) $62,700
Expenses:
Salaries expense (Hint: $11300 Dr.-$10000 Dr.= $1300 Dr. Exp.; Cr. Payable) $11,300
Depreciation expense (Hint: $6000 Dr. Bal.= $6000 Dr. Exp.; Cr. Acc/Depr) ?
Rent expense (Hint: $4000 - $4000 = no adjusting entry made) 4,000
Art Supplies expense (Hint: $3600 Dr. bal. = $3600 Dr. Exp.; Cr. Art Sup.) ?
Insurance expense (Hint: $850 Dr. Bal. =$850 Dr. Exp.; Cr. Prepaid Ins.) 850
Interest expense (Hint: $500 Dr.-$350 Dr. = $150 Dr. Exp.; Cr. Int.Payable) ?
Total expenses 26,250
Net income $?
Form for the Owner's Equity Statement:
FERNETTI ADVERTISING AGENCY
Owner's Equity Statement
For the Year Ended December 31, 2008

J. Fernetti, capital, January 1 $0


Add: Net income ?
61,950
Less: Drawing ?
J. Fernetti, capital, December 31 $49,950
Form for the Balance Sheet:
FERNETTI ADVERTISING AGENCY
Balance Sheet
December 31, 2008
Assets
Cash $11,000
Accounts receivable ?
Art supplies ?
Prepaid insurance ?
Printing equipment $60,000
Less: Accumulated depreciation 34,000 ?
Total assets $67,000
Liabilities and Owner's Equity
Liabilities:
Notes payable $5,000
Accounts payable ?

26
Unearned advertising fees ?
Salaries payable ?
Interest payable ?
Total liabilities 17,050
Owner's equity:
J. Fernetti, capital ?
Total liabilities and owner's equity $67,000
(1) If the note has been outstanding 6 months, what is the annual interest rate on that
note?
(Explain with computations)
I=PxRxT
$150 = $ 5,000 x R x ½
$150 = $2,500R
R= $150/ ? = ? %.
(2) If the company paid $12,500 in salaries in 2008, what was the balance in Salaries
Payable, on December 31, 2007:
Salaries Expense, 2008 = $11,300 – Salaries Payable 12/31/08, $1,300 = $10,000.
Total salaries paid, 2008 = $12,500 - $10,000 = Salaries Payable 12/31/07

Refer to HOMEWORK PROBLEM BYP3-1 that requires identification of items on


the financial statements for adjusting entries, etc. of PepsiCo:
(a) Items that may have resulted in adjusting entries for prepayments are:

1. Prepaid expenses and other current assets (per balance sheet).

2. Property, plant, and equipment, net of ? (per balance sheet).

3. Amortization intangible assets, net (per balance sheet)--amortization is similar


to depreciation (explained later in Chapter 10).

(b) Using the consolidated financial statements of PepsiCo and related information,
identify items that may result in adjusting entries for accruals:
Accrual adjusting entries were probably made for accounts ? and other current ?
interest expense, and income taxes ?

(c ) Using the Selected Financial Data and 5-Year Summary, what has been the trend since
1998 for net income?
As indicated in the 5-Year Summary, the trend in net income has been ? (Hint:
Positive or Negative). In every year since 2001 (except for ?), net income has ?
(Hint: increased or decreased) In 2001 net income was $? million and in 2005 it was
$? million.

27
Refer to HOMEWORK PROBLEM BYP3-2 to determine the following amounts:
PepsiCo Coca-Cola
Net increase (decrease) in property, plant, and
equipment (net) from 2004 to 2005. $532,000,000 ($305,000,000)

Increase (decrease) in selling, general, and


administrative expenses from 2004 to 2005. $? $849,000,000

Increase (decrease) in long-term debt


(obligations) from 2004 to 2005. ($84,000,000) $?

Increase (decrease) in net income from 2004


to 2005. $? $25,000,000

Increase (decrease) in cash and cash


equivalents from 2004 to 2005. $? $?

Refer to HOMEWORK PROBLEM BYP3-6 ETHICS for partial help:


(b) What are the ethical considerations of (1) the president's request and (2) Cathi’s
dating the adjusting entries December 31?
1. It is unethical for the president to place pressure ??????????????????.

2. It is customary for adjusting entries to be dated as of the balance sheet date although the
entries are prepared at a later date. Cathi did nothing unethical by ??????????.
(c ) Can Cathi accrue revenues and defer expenses and still be ethical?
Cathi can accrue revenues and defer expenses through the preparation of adjusting entries
and be ethical so long as the entries reflect economic reality. So she needs to make sure that
she is matching the ?????? in the same accounting period. Intentionally misrepresenting
the company's financial condition and its results of operations is ? (it is also illegal).

Retake opening Quiz and then check your answers as follows:


1. True
2. False. The cash account NEVER appears as an adjusting entry.
3. True
4. (1) Accrued expense
5. (4) Deferred revenue
6. (3) Deferred expense
7. (2) Accrued revenue
8. (3) Deferred expense
9. (4) Deferred revenue
10. (2) Accrued revenue
11. (1) Accrued expense

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