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# CHAPTER 4

## Income Measurement and

Accrual Accounting
OVERVIEW OF EXERCISES, PROBLEMS, AND CASES
Exercises

Estimated
Time in
Minutes

Level

## 1. Explain the significance of recognition and measurement

in the preparation and use of financial statements.

18*

20

Diff

## 2. Explain the differences between the cash and accrual

bases of accounting.

18*

20

Diff

## 3. Describe the revenue recognition principle and explain its

application in various situations.

1
18*

10
20

Easy
Diff

## 4. Describe the matching principle and the various methods

for recognizing expenses.

2
19*
20*

10
15
15

Mod
Mod
Mod

## 5. Identify the four major types of adjustments and determine

their effect on the accounting equation.

3
4
5
6
7
8
9
10
11
12
13
14
15
16
19*
20*

10
10
20
20
15
15
15
15
15
15
15
15
10
15
15
15

Easy
Easy
Easy
Easy
Easy
Easy
Easy
Mod
Easy
Easy
Easy
Easy
Mod
Mod
Mod
Mod

## 6. Explain the steps in the accounting cycle and the significance

of each step.

17

Easy

Learning Objective

## *Exercise, problem, or case covers two or more learning objectives

Level = Difficulty levels: Easy; Moderate (Mod); Difficult (Diff)

4-1

4-2

Estimated
Time in
Minutes

Level

8*

25

Mod

8*
9*

25
25

Mod
Diff

8*
9*

25
25

Mod
Diff

## 5. Identify the four major types of adjustments and determine

their effect on the accounting equation.

1
2
3
4
5
6
7
10*

20
20
20
15
20
25
15
60

Mod
Mod
Mod
Mod
Mod
Mod
Mod
Mod

## 6. Explain the steps in the accounting cycle and the significance

of each step.

10*

90

Mod

Learning Objective

Problems
and
Alternates

## 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
bases of accounting.
3. Describe the revenue recognition principle and explain its
application in various situations.
4. Describe the matching principle and the various methods
for recognizing expenses.

## *Exercise, problem, or case covers two or more learning objectives

# Original problem only
**Alternate problem only
Level = Difficulty levels: Easy; Moderate (Mod); Difficult (Diff)

## CHAPTER 4 INCOME MEASUREMENT AND ACCRUAL ACCOUNTING

Learning Objective

Cases

## 1. Explain the significance of recognition and measurement

in the preparation and use of financial statements.

Estimated
Time in
Minutes

Level

1*

30

Mod

## 2. Explain the differences between the cash and accrual

bases of accounting.

1*
3*
5*

30
30
60

Mod
Mod
Diff

## 3. Describe the revenue recognition principle and explain its

application in various situations.

1*
2
3*
5*

30
30
30
60

Mod
Mod
Mod
Diff

3*
4
5*
6

30
25
60
45

Mod
Mod
Diff
Mod

5*

60

Diff

## 4. Describe the matching principle and the various methods

for recognizing expenses.

## 5. Identify the four major types of adjustments and determine

their 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 objectives
Level = Difficulty levels: Easy; Moderate (Mod); Difficult (Diff)

4-3

4-4

## FINANCIAL ACCOUNTING SOLUTIONS MANUAL

QUESTIONS
1.

The accountant cannot show a stockholder or other user the companys assets,
such as cash and buildings. Instead, what the user sees is a representation or
depiction 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.
Sometimes, 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 bankers 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 assetthat is, its
historical costmay be more reliable, although not as relevant to the bankers
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
recognized 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
information on the future cash flow prospects for a company. An income
statement may in fact provide more important information about future cash flows.
For example, 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 accrued expenses that will result in a cash outlay in future periods.

5.

## The time period assumption is important in accounting because financial

statement 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
business for the most recent year. Under an accrual accounting system, revenues
are recognized when they are earned regardless of when cash is received, and
expenses 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.

## CHAPTER 4 INCOME MEASUREMENT AND ACCRUAL ACCOUNTING

4-5

6.

No, the recognition of revenue is not always the result of the acquisition of an
asset. 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
liability. As each months magazine is mailed to the customer, a portion of the
liability is satisfied and revenue is recognized. Thus, in some instances, revenue
results 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
unexpired 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
adjustment 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
example, a publisher has to make an adjustment at the end of each period to
recognize the earned portion of a subscription.
c. To recognize expense at the end of the period before cash is paid. For
example, an adjustment is made at the end of the year to recognize income
tax expense, 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
example, 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.

4-6

## FINANCIAL ACCOUNTING SOLUTIONS MANUAL

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 accounts
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 associated 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.
Second, the net income and the dividends of the period are transferred to the
Retained Earnings account.

EXERCISES

LO 3

## Cash collected at toll booth

Passes redeemed
Revenue recognized

\$ 3,000,000
1,700,000
\$ 4,700,000

Only the amount of passes that have been used should be recognized as revenue. 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. b

LO 5
1.
2.
3.
4.

AL
DR
AA
DE

LO 5

4-7

5.
6.
7.
8.

DE
DR
AL
AA

BALANCE SHEET
Assets

Liabilities

INCOME

STATEMENT

## 5/31 Office Supplies

on Hand (1,630)
(1,450 + 1,100
920)

Office Supplies
Expense
(1,630)

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

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

2. To record prepayment of six months rent on September 1.
BALANCE SHEET
Assets
9/1 Prepaid
Rent
Cash

Liabilities

INCOME

STATEMENT

12,000
(12,000)

BALANCE SHEET
Assets
9/30 Prepaid
Rent

Liabilities

INCOME

STATEMENT

## Stockholders Equity + Revenues Expenses

Rent Expense

(2,000)

(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).

4-8

LO 5

BALANCE SHEET
Assets

Liabilities

INCOME

STATEMENT

## 7/1 Equipment 100,000

Cash
(100,000)

2. Purchase price
Less: Estimated salvage value
Depreciable cost

\$ 100,000
(16,000)
\$ 84,000

## 3. Monthly depreciation = depreciable cost/estimated life = \$84,000/84 months =

\$1,000/month.
4. To record one months depreciation expense on July 31.
BALANCE SHEET
Assets

Liabilities

INCOME

7/31 Accumulated
Depreciation (1,000)

Depreciation
Expense

5. Equipment
Less: Accumulated depreciation (6 months
\$1,000/month)
Carrying value

LO 5

STATEMENT

(1,000)

\$ 100,000
(6,000)
\$ 94,000

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

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

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

Liabilities

INCOME

STATEMENT

4-9

BALANCE SHEET
Assets

INCOME

Liabilities

STATEMENT

## Stockholders Equity + Revenues Expenses

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

Insurance
Expense

LO 5

BALANCE SHEET
Assets
Aug. Cash

=
27,000

Liabilities
Subscriptions
(900 30)

INCOME

STATEMENT

27,000

BALANCE SHEET
Assets
8/31

Liabilities

INCOME

STATEMENT

## Stockholders Equity + Revenues Expenses

Subscriptions
(7,500)
(40,500 + 27,000 60,000)

Revenue

Subscriptions
7,500

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

4-10

## EXERCISE 4-9 CUSTOMER DEPOSITS

LO 5

1. To record on April 1 receipt of customer deposit for three months of legal service.
BALANCE SHEET
Assets
4/1

Cash

=
9,000

INCOME

Liabilities
Customer
Deposits

STATEMENT

9,000

BALANCE SHEET
Assets

4/30

INCOME

Liabilities
Customer
Deposits
(9,000/3)

STATEMENT

## Stockholders Equity + Revenues Expenses

Legal Fees
Earned

(3,000)

3,000

3. If the April 30 adjustment is not recorded, net income will be understated by \$3,000.
EXERCISE 4-10 WAGES PAYABLE

LO 5

1. Weekly payroll:
\$17,500

BALANCE SHEET
Assets
10/27 Cash

INCOME

Liabilities

STATEMENT

(17,500)

BALANCE SHEET
Assets

10/31

INCOME

Liabilities
Wages Payable
(17,500/5 days

STATEMENT

7,000
2 days)

Wages Expense

(7,000)

BALANCE SHEET
Assets
11/3 Cash

Liabilities

INCOME

+
(7,000)

STATEMENT

Wages Expense

(10,500)

## CHAPTER 4 INCOME MEASUREMENT AND ACCRUAL ACCOUNTING

4-11

5. Net income for October would be overstated by \$7,000 if the company failed to
record accrued wages on October 31.
EXERCISE 4-11 INTEREST PAYABLE
LO 5
1. To record 12%, 90-day loan from First National Bank on March 1.
BALANCE SHEET
Assets
3/1 Cash

Liabilities

INCOME

STATEMENT

100,000

BALANCE SHEET
Assets

3/31

Liabilities

INCOME

STATEMENT

## Stockholders Equity + Revenues Expenses

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

BALANCE SHEET
Assets

4/30

Liabilities
Interest Payable

INCOME

STATEMENT

1,000

Interest Expense

(1,000)

BALANCE SHEET
Assets
5/30 Cash

LO 5

(103,000)

Liabilities
Note Payable
Interest
Payable

INCOME

STATEMENT

(100,000)

Interest Expense

(1,000)

(2,000)

BALANCE SHEET
Assets
2007
12/31

Liabilities
Property Taxes
Payable
(50,000 1.05)

INCOME

52,500

STATEMENT

Property Tax
Expense

(52,500)

4-12

BALANCE SHEET
Assets
2008
6/1 Cash

LO 5
1.

Liabilities

Payable

INCOME

(52,500)

BALANCE SHEET
Assets

6/1

2.

Liabilities

INCOME

STATEMENT

## Stockholders Equity + Revenues Expenses

Cash
(60,000)
Note
Receivable 60,000

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

BALANCE SHEET
Assets

Liabilities

INCOME

6/30 Interest
Receivable 500
(60,000 .10 30/360)

3.

STATEMENT

STATEMENT

Interest
Income

500

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

BALANCE SHEET
Assets

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

Liabilities

INCOME

STATEMENT

Interest Income

500

4-13

LO 5

## 1. Under the revenue recognition principle, revenue should be recorded when

services are performed, because this is the point at which revenue is earned.
2. To record on June 30 unbilled service fees earned during June.
BALANCE SHEET
Assets
6/30

Liabilities

Service Fees
Earned

LO 6

40,000

ON NET INCOME

1. O
2. U
3. O

1.
2.
3.
4.
5.
6.

STATEMENT

## Stockholders Equity + Revenues Expenses

Accounts
Receivable 40,000

LO 5

LO 5

INCOME

4. O
5. O
6. U
EXERCISE 4-16 THE EFFECT OF ADJUSTMENTS ON THE
ACCOUNTING EQUATION

Assets
D
NE
D
NE
I
NE

Liabilities
NE
I
NE
D
NE
I

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

Stockholders Equity
D
D
D
I
I
D

4-14

## FINANCIAL ACCOUNTING SOLUTIONS MANUAL

MULTI-CONCEPT EXERCISES
LO 1,2,3

ACCRUAL BASIS

## 1. Accrual-basis income statements:

HATHAWAY HEALTH CLUB
INCOME STATEMENTS
FOR THE YEARS ENDED DECEMBER 31
Sales*\$
Expenses:
Depreciation**
Salaries and wages
Rent and utilities
Total expenses
Net income (loss)

Year 1
122,000

Year 2
\$152,000

Year 3
\$ 182,000

\$ 33,000
50,000
5,000
36,000
\$124,000
\$ (2,000)

\$ 33,000
50,000
5,000
36,000
\$124,000
\$ 28,000

\$ 33,000
50,000
5,000
36,000
\$ 124,000
\$ 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
memberships 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
profitability of the business rather than simply on the amount of cash received in
any given year.

LO 4,5

4-15

1. Depreciation
Truck
Computer
Building

## expense for 2007:

[(\$18,000 \$3,000)/5] 9/12
[(\$55,000 \$5,000)/10] 6/12
[(\$250,000 \$10,000)/30] 3/12

=
=
=

\$2,250
\$2,500
\$2,000

2. Certainly, it would be less costly in terms of the time spent by the accountant to
expense 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

BALANCE SHEET
Assets
a. 7/1 Cash

Liabilities

INCOME

STATEMENT

50,000

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

BALANCE SHEET
Assets

b. 7/31

Liabilities

INCOME

Interest Payable
500
(50,000 .12 1/12)

STATEMENT

Interest Expense

(500)

BALANCE SHEET
Assets
c. 8/31 Cash

2.

Liabilities

Notes Payable

INCOME

+
(500)
(50,000)

STATEMENT

## Stockholders Equity + Revenues Expenses

Interest Expense

(500)

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
understated and the expense for August would be overstated.

4-16

PROBLEMS

LO 5

## 1. Adjustments on March 31, 2007:

To accrue interest.
BALANCE SHEET
Assets

a. 3/31

Liabilities

INCOME

Interest Payable
100
(15,000 .08 30/360)

STATEMENT

Interest Expense

(100)

BALANCE SHEET
Assets

Liabilities

INCOME

## b. 3/31 Office Supplies

on Hand
(660)
(1,280 + 750 1,370)

STATEMENT

## Stockholders Equity + Revenues Expenses

Supplies Expense

(660)

To record depreciation.
BALANCE SHEET
Assets
c. 3/31

Liabilities

INCOME

Accumulated
Depreciation
Office
Equipment (800)
(62,600 5,000) 1/72

STATEMENT

Depreciation
Expense

(800)

To accrue wages.
BALANCE SHEET
Assets

d. 3/31

Liabilities
Wages Payable
(950 6)

INCOME

+
5,700

STATEMENT

Wages Expense

(5,700)

BALANCE SHEET
Assets
e. 3/31

Liabilities
Rent Collected

INCOME

STATEMENT

Rent Revenue

(2,500)

2,500

BALANCE SHEET
Assets

f. 3/31

Liabilities
Customer
Deposits
(4,800/4)

INCOME

STATEMENT

Service Revenue

1,200

(1,200)

BALANCE SHEET
Assets

g. 3/31

Liabilities
Income Tax
Payable

INCOME

STATEMENT

## Stockholders Equity + Revenues Expenses

Income Tax
Expense

3,900

Rent revenue
Service revenue
Interest expense
Supplies expense
Depreciation expense
Wages expense
Income tax expense
LO 5

(3,900)

\$ 23,000
+ 2,500
+ 1,200
(100)
(660)
(800)
(5,700)
(3,900)
\$ 15,540

## 1. Adjustments on December 31, 2007:

To record annual depreciation expense.
BALANCE SHEET
Assets
a. 12/31

Liabilities

INCOME

STATEMENT

## Stockholders Equity + Revenues Expenses

Accumulated
Depreciation (2,950)
(15,000 250)/5 years

Depreciation
Expense

(2,950)

## To record supplies used during the year.

BALANCE SHEET
Assets

Liabilities

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

INCOME

STATEMENT

Supplies
Expense

(19,350)

4-17

4-18

BALANCE SHEET
Assets

c. 12/31

Liabilities

INCOME

STATEMENT

## Stockholders Equity + Revenues Expenses

Customer
Deposits
(20,000)
(24,000/6 months) 5 months

Fees Earned

20,000

BALANCE SHEET
Assets

Liabilities

INCOME

STATEMENT

(2,700 2)

Rent Expense

(5,400)

BALANCE SHEET
Assets

e. 12/31

Liabilities

INCOME

STATEMENT

## Stockholders Equity + Revenues Expenses

Interest Payable
3,000
(200,000 .09 60/360)

Interest Expense

(3,000)

BALANCE SHEET
Assets
f. 12/31

Liabilities
Wages Payable

INCOME

STATEMENT

500

## 2. Net increase (decrease) in net income from adjustments:

a. Depreciation expense
b. Supplies expense
c. Fees earned
d. Rent expense
e. Interest expense
f. Wage expense
Overstatement of 2007 net income

Wage Expense

(500)

\$ (2,950)
(19,350)
20,000
(5,400)
(3,000)
(500)
\$ (11,200)

LO 5
a.
b.
c.
d.
e.
f.
g.
h.

4-19

1, 12, 13
5, 1
7, 1, 11
3, 1
4, 8
1, 14
1, 2
2, 14

i.
j.
k.
l.
m.
n.
o.

8, 1
17, 9
15, 4
16, 3
11, 19, 1
18, 6
20, 10

LO 5

## 1. Adjustments on December 31, 2007:

To recognize expired insurance.
BALANCE SHEET
Assets

Liabilities

INCOME

STATEMENT

## Stockholders Equity + Revenues Expenses

a. 12/31 Prepaid
Insurance (1,000)
(7,200 5/36)

Insurance
Expense

(1,000)

## To recognize rent earned.

BALANCE SHEET
Assets

b. 12/31

Liabilities

INCOME

Rent Collected in
(6,000 7/12)

STATEMENT

Rent Revenue

3,500

(3,500)

## To recognize interest earned.

BALANCE SHEET
Assets

Liabilities

c. 12/31 Interest
Receivable 1,500
(50,000 .09 4/12)

INCOME

STATEMENT

## Stockholders Equity + Revenues Expenses

Interest Revenue

1,500

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
occasions: August 31, September 30, October 31, and November 30. Thus, the
balance in the account before the December adjustment would be \$7,200 [(4)
(\$200)] = \$6,400.

4-20

LO 5

## 1. Adjustments on April 30, 2007:

To recognize one months insurance expense.
BALANCE SHEET
Assets

Liabilities

INCOME

STATEMENT

## Stockholders Equity + Revenues Expenses

Insurance Expense

(50)

## To record supplies used.

BALANCE SHEET
Assets
b. Office Supplies
(250 180)

Liabilities

INCOME

(70)

STATEMENT

## Stockholders Equity + Revenues Expenses

Office Supplies
Expense

(70)

To record depreciation.
BALANCE SHEET
Assets

Liabilities

INCOME

c. Accumulated
Depreciation
Office Equipment
(417)
(50,000 1/120)

STATEMENT

## Stockholders Equity + Revenues Expenses

Depreciation
Expense

(417)

To record depreciation.
BALANCE SHEET
Assets

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

Liabilities

INCOME

STATEMENT

Depreciation
Expense

(200)

4-21

BALANCE SHEET
Assets

e.

Liabilities
Unearned
Commissions
(9,500 5,000)

INCOME

STATEMENT

Commissions
Earned

(4,500)

4,500

BALANCE SHEET
Assets
f. Accounts
Receivable

Liabilities

INCOME

STATEMENT

Commissions
Earned

1,500

1,500

BALANCE SHEET
Assets

g.

Liabilities

INCOME

Interest Payable

STATEMENT

20

Interest Expense

(20)

BALANCE SHEET
Assets
h.

Liabilities
Salaries Payable

INCOME

STATEMENT

2,500

## 2. Net increase (decrease) in net income from adjustments:

Insurance expense
Office supplies expense
Depreciation expense
Depreciation expense
Commissions earned
Commissions earned
Interest expense
Salaries expense
Net increase in net income

Salaries Expense

(2,500)

(50)
(70)
(417)
(200)
4,500
1,500
(20)
(2,500)
\$ 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.

4-22

LO 5

ACCOUNT BALANCES

BALANCE SHEET
Assets

Liabilities

INCOME

STATEMENT

## 6/30 Prepaid Insurance (150)

(3,600 3,450)

Insurance Expense

(150)

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

3. To record depreciation expense on June 30.
BALANCE SHEET
Assets

Liabilities

INCOME

STATEMENT

## Stockholders Equity + Revenues Expenses

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

Depreciation
Expense

(80)

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

5. To record interest expense on June 30.
BALANCE SHEET
Assets

6/30

Liabilities
Interest Payable
(2,448 2,304)

INCOME

STATEMENT

144

Interest Expense

(144)

## 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

To record rent expense.
BALANCE SHEET
Assets
a. Prepaid Rent

=
(600)

Liabilities

INCOME

STATEMENT

Rent Expense

(600)

BALANCE SHEET
Assets

INCOME

Liabilities

STATEMENT

Video Expense

(2,460)

BALANCE SHEET
Assets
c. Accumulated
Depreciation

INCOME

Liabilities

STATEMENT

Depreciation
Expense

(140)

(140)

BALANCE SHEET
Assets

d.

INCOME

Liabilities
Wages and
Salaries
Payable

STATEMENT

Wages and
Salary
Expense

1,450

(1,450)

BALANCE SHEET
Assets

e.

INCOME

Liabilities

Customer
Subscriptions

STATEMENT

(2,440)

Subscription
Revenue

2,440

## To record accrued income taxes.

BALANCE SHEET
Assets

f.

Liabilities

Income Taxes
Payable

Explanations:
(a) \$7,200/12 months
(b) \$25,600 \$23,140
(c) (\$8,900 \$500)/60 months

INCOME

+
849

STATEMENT

Income Tax
Expense

(849)

4-23

4-24

## (f) Calculation of taxes due:

Subscription revenue
Rental revenue
Wage and salary expense (\$2,320 + \$1,450)
Utility expense
Rent expense
Video expense
Depreciation expense
Income before tax
tax rate
Income tax expense

\$ 2,440
9,200
(3,770)
(1,240)
(600)
(600)
(2,460)
(140)
\$ 2,830
0.30
\$
849

## 2. On the basis of the information available, Four Star appears to be a profitable

business. 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%.
MULTI-CONCEPT PROBLEMS

LO 2,3,4

## PROBLEM 4-8 CASH AND ACCRUAL INCOME

STATEMENTS FOR A MANUFACTURER

## 1. Cash revenue: 500,000 components \$2

Cash revenue
Accrual revenue: 500,000 components \$2

\$ 1,000,000
150,000
\$ 850,000
\$ 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.

4-25

## 3. Income statement under the accrual basis:

DRYSDALE COMPANY
INCOME STATEMENT
FOR THE YEAR ENDED XX/XX/XX
Sales revenue
Cost of goods sold
Gross profit
Operating expenses:
Truck depreciation
Total operating expenses
Net income

\$ 1,000,000
602,000*
\$ 398,000
\$
\$
\$

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

\$
\$

100,000
2,000**
102,000
296,000
12,000
400,000
190,000
602,000

**\$10,000/5 years

LO 3,4

RECOGNITION

## Income statements for Years 1 and 2:

DARBY DELIVERY SERVICE
INCOME STATEMENTS
Sales revenue (a)
Expenses:
Salaries (c)
Rent (d)
Total expenses
Net income

Year 1
\$ 23,000

Year 2
\$ 46,000

\$ 2,000
15,000
5,000
\$ 22,000
\$ 1,000

\$ 1,500
24,000
5,000
\$ 30,500
\$ 15,500

4-26

## PROBLEM 4-9 (Concluded)

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

\$3,500

500

## Total weekly expense

\$3,000 or \$1,500/year

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

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

## 1. Effects on the accounting equation:

To record issuance of stock to owners on January 2.
BALANCE SHEET
Assets
1/2 Cash
60,000
(3 20,000)

Liabilities

INCOME

STATEMENT

Capital
Stock

60,000

BALANCE SHEET
Assets
1/2 Land
House
Cash

Liabilities

INCOME

STATEMENT

15,000
35,000
(50,000)

BALANCE SHEET
Assets
1/3 Cash

=
30,000

Liabilities
Notes Payable

INCOME

STATEMENT

30,000

BALANCE SHEET
Assets
1/4 Furniture
Cash

Liabilities

INCOME

STATEMENT

15,000
(15,000)

BALANCE SHEET
Assets
1/5 Prepaid
Insurance
Cash

Liabilities

INCOME

STATEMENT

6,000
(6,000)

BALANCE SHEET
Assets
1/6 Cash

Liabilities

INCOME

(450)

STATEMENT

Expense

(450)

BALANCE SHEET
Assets
1/7 Cleaning
Supplies

Liabilities
Accounts Payable

950

INCOME

+
950

STATEMENT

4-27

4-28

BALANCE SHEET
Assets
1/15 Cash

Liabilities

INCOME

STATEMENT

(4,230)

Wages Expense

(4,230)

BALANCE SHEET
Assets
1/16 Cash

Liabilities

INCOME

STATEMENT

980

BALANCE SHEET
Assets
1/31 Cash

Liabilities

INCOME

STATEMENT

## Stockholders Equity + Revenues Expenses

8,300

Revenue from
Rental of Rooms 8,300

BALANCE SHEET
Assets
1/31 Cash

Liabilities

INCOME

STATEMENT

6,600

Restaurant
Revenue

6,600

BALANCE SHEET
Assets
1/31 Cash
(3 200)

=
(600)

Liabilities

INCOME

STATEMENT

Dividends

(600)

## 2. List of accounts and account balances:

Assets
Cash
Land
House
Furniture
Prepaid Insurance
Cleaning Supplies

\$ 29,600
15,000
35,000
15,000
6,000
950

Liabilities
Accounts Payable
Notes Payable

Owners Equity
Capital Stock
Wages Expense
Revenue from Rental of Rooms
Restaurant Revenue
Dividends

950
30,000
980

\$ 60,000
450
4,230
8,300
6,600
600

To record depreciation expense on the house.
BALANCE SHEET
Assets

Liabilities

INCOME

STATEMENT

a. Accumulated
Depreciation
House
(100)

Depreciation
Expense

(100)

BALANCE SHEET
Assets

Liabilities

INCOME

b. Accumulated
Depreciation
Furniture
(125)

STATEMENT

Depreciation
Expense
Furniture

(125)

BALANCE SHEET
Assets
c.

Liabilities
Interest Payable

INCOME

+
300

STATEMENT

Interest Expense

(300)

4-29

4-30

BALANCE SHEET
Assets

Liabilities

INCOME

STATEMENT

## d. Prepaid Insurance (250)

Insurance Expense

(250)

BALANCE SHEET
Assets

e.

Liabilities

INCOME

STATEMENT

Revenue from
Rental of Rooms

490

BALANCE SHEET
Assets
f.

Liabilities

Wages Payable

INCOME

+
5,120

STATEMENT

Wages Expense

(5,120)

BALANCE SHEET
Assets

Liabilities

INCOME

STATEMENT

Supplies Expense

(720)

## To record utility expense.

BALANCE SHEET
Assets

h.

Liabilities
Utilities Payable

INCOME

+
740

STATEMENT

## Stockholders Equity + Revenues Expenses

Utilities Expense

(740)

BALANCE SHEET
Assets
i.

Liabilities
Income Tax
Payable

INCOME

+
1,007

STATEMENT

Income Tax
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)

## (g) \$950 \$230 = \$720 used

(h) \$740 due at end of month
(i) Calculation of tax expense:
Revenue from rental of rooms
Restaurant revenue
Wages expense
Depreciation on house
Depreciation on furniture
Interest expense
Insurance expense
Supplies expense
Utilities expense
Income before tax
Tax rate
Income tax expense

\$ 8,790
6,600
(9,350)
(450)
(100)
(125)
(300)
(250)
(720)
(740)
\$ 3,355
0.30
\$ 1,007

4-31

4-32

## PROBLEM 4-10 (Continued)

4. Financial statements:
(a)

## MOONLIGHT BAY INN

INCOME STATEMENT
FOR THE MONTH ENDED JANUARY 31, 2007

Revenues:
From rental of rooms
From restaurant
Total revenues
Expenses:
Wages
Depreciationhouse
Depreciationfurniture
Interest
Insurance
Supplies
Utilities
Income taxes
Total expenses
Net income
(b)

\$ 8,790
6,600
\$ 15,390
\$

450
9,350
100
125
300
250
720
740
1,007
13,042
\$ 2,348

## MOONLIGHT BAY INN

STATEMENT OF RETAINED EARNINGS
FOR THE MONTH ENDED JANUARY 31, 2007

## Beginning balance, January 1, 2007

Deduct: Cash dividends
Ending balance, January 31, 2007

0
2,348
600
\$ 1,748

4-33

(c)

## MOONLIGHT BAY INN

BALANCE SHEET
JANUARY 31, 2007

Assets
Current assets:
Cash
Cleaning supplies
Prepaid insurance
Total current assets
Property, plant, and equipment:
Land
House
Less: Accumulated
depreciation
Furniture
Less: Accumulated
depreciation
Total property, plant, and
equipment
Total assets
Liabilities
Current liabilities:
Accounts payable
Interest payable
Wages payable
Income tax payable
Utilities payable
Total current liabilities
Long-term debt:
Notes payable
Total liabilities
Stockholders Equity
Capital stock
Retained earnings
Total stockholders equity
Total liabilities and stockholders
equity

\$ 29,600
230
5,750
\$ 35,580
\$ 15,000
\$ 35,000
100
\$ 15,000

34,900

125

14,875
64,775
\$ 100,355
\$

950
300
5,120
1,007
490
740
\$

8,607

30,000
\$ 38,607
\$ 60,000
1,748
\$ 61,748
\$ 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
statements alone, it appears that the banker should be comfortable with the

4-34

## FINANCIAL ACCOUNTING SOLUTIONS MANUAL

ALTE R N ATE P R O B L E M S

LO 5

## 1. Adjustments on June 30, 2007:

a. To accrue interest: \$10,000 4% 1/12.
BALANCE SHEET
Assets

Liabilities

INCOME

STATEMENT

Interest Revenue

33

BALANCE SHEET
Assets

Liabilities

INCOME

STATEMENT

on Hand
(5,568)

Supplies Expense

(5,568)

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

BALANCE SHEET
Assets

Liabilities

INCOME

6/30 Accumulated
Depreciation
Machinery (3,500)

STATEMENT

Depreciation
Expense

(3,500)

BALANCE SHEET
Assets

Liabilities

INCOME

STATEMENT

Rent Expense

(1,550)

BALANCE SHEET
Assets
6/30

Liabilities
Wages Payable

INCOME

+
6,000

STATEMENT

Wages Expense

(6,000)

4-35

f.

BALANCE SHEET
Assets

6/30

2.

Liabilities
Income Taxes
Payable

INCOME

## Stockholders Equity + Revenues Expenses

Income Tax
Expense

2,900

Interest revenue
Supplies expense
Depreciation expense
Rent expense
Wages expense
Income tax expense

LO 5

STATEMENT

(2,900)

\$ 35,000
33
(5,568)
(3,500)
(1,550)
(6,000)
(2,900)
\$ 15,515

a. To record annual depreciation expense: (\$25,000 \$4,000)/7 years.
BALANCE SHEET
Assets
12/31 Accumulated
Depreciation

Liabilities

INCOME

STATEMENT

Depreciation
Expense

(3,000)

(3,000)

BALANCE SHEET
Assets
12/31 Supplies
on Hand

Liabilities

INCOME

STATEMENT

Supplies
Expense

(13,200)

(13,200)

## c. To record customer deposits earned between July and December: (\$8,800/8

months) 6 months.
BALANCE SHEET
Assets
12/31

Liabilities
Customer
Deposits

INCOME

STATEMENT

Fees Earned

(6,600)

6,600

4-36

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

BALANCE SHEET
Assets
12/31 Prepaid Rent

INCOME

Liabilities

STATEMENT

(16,000)

Rent Expense

(16,000)

BALANCE SHEET
Assets
12/31

INCOME

Liabilities

Interest Payable

f.

300

Interest Expense

BALANCE SHEET
12/31

INCOME

Liabilities

Wages Payable

830

1, 11, 12
5, 1
2, 1
4, 7
1, 3
1,18
16,1
5, 1,10

i.
j.
k.
l.
m.

STATEMENT

## 2. Net increase (decrease) in net income from adjustments:

a. Depreciation expense
b. Supplies expense
c. Fees earned
d. Rent expense
e. Interest expense
f. Wage expense
Overstatement of 2007 net income

a.
b.
c.
d.
e.
f.
g.
h.

(300)

Assets

LO 5

STATEMENT

2, 13
17, 6
19, 9
14, 4
15, 3

Wage Expense

(830)

(3,000)
(13,200)
6,600
(16,000)
(300)
(830)
\$ (26,730)

LO 5

4-37

## 1. Adjustments on December 31, 2007:

a. To record supplies used: \$5,790 \$1,520.
BALANCE SHEET
Assets
12/31 Supplies

Liabilities

INCOME

STATEMENT

(4,270)

Supplies
Expense

(4,270)

BALANCE SHEET
Assets

12/31

Liabilities
Unearned
Revenue

INCOME

STATEMENT

Service Revenue

1,200

(1,200)

BALANCE SHEET
Assets
12/31

Liabilities
Interest
Payable

INCOME

STATEMENT

## Stockholders Equity + Revenues Expenses

Interest Expense

(2,000)

2,000

2. If adjustments were made at the end of each month, the Unearned Revenue
account 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.

4-38

LO 5

## 1. Adjustments on June 30, 2007:

a. To recognize one month's rent expense.
BALANCE SHEET
Assets

Liabilities

INCOME

STATEMENT

Rent Expense

(600)

BALANCE SHEET
Assets

Liabilities

INCOME

STATEMENT

## Stockholders Equity + Revenues Expenses

6/30 Office
Supplies (13,920)

Supplies
Expense

(13,920)

BALANCE SHEET
Assets

Liabilities

INCOME

STATEMENT

6/30 Accumulated
Depreciation
Equipment
(333)

Depreciation
Expense

(333)

BALANCE SHEET
Assets

6/30

Liabilities

INCOME

Interest Payable

e.

50

Interest Expense

(50)

BALANCE SHEET
Assets

6/30

STATEMENT

Liabilities
Salaries Payable

INCOME

+
620

STATEMENT

Salaries Expense

(620)

4-39

## 2. Net increase (decrease) in net income from adjustments:

a.
b.
c.
d.
e.
Net decrease in net income from adjustments

(600)
(13,920)
(333)
(50)
(620)
\$ (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

BALANCE SHEET
Assets

Liabilities

INCOME

STATEMENT

## 6/30 Prepaid Rent (1,000)

Rent Expense

(1,000)

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.
BALANCE SHEET
Assets

Liabilities

INCOME

STATEMENT

## Stockholders Equity + Revenues Expenses

6/30 Accumulated
Depreciation (100)

Depreciation
Expense

(100)

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

5. To record interest expense on June 30: \$864 \$768.
BALANCE SHEET
Assets
6/30

Liabilities
Interest Payable

INCOME

STATEMENT

## Stockholders Equity + Revenues Expenses

96

Interest Expense

(96)

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

4-40

LO 5

BALANCE SHEET
Assets
a. Prepaid Rent

INCOME

Liabilities

(400)

Rent Expense

BALANCE SHEET
Assets
b. Accumulated
Depreciation

INCOME

Liabilities

c. Chemical
Inventory

INCOME

Liabilities

d.

INCOME

Liabilities
Wages and
Salaries
Payable

e.

Income Taxes
Payable

INCOME

+
1,881

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

(b) (\$18,200 \$200)/120 months = \$150/month
(\$9,400 \$1,300) = \$8,100

STATEMENT

Explanations:

(c)

STATEMENT

Wages and
Salary
Expense
(1,080)

1,080

Liabilities

(8,100)

BALANCE SHEET
Assets

STATEMENT

Chemical
Expense

(8,100)

(150)

BALANCE SHEET
Assets

STATEMENT

Depreciation
Expense

(150)

(400)

BALANCE SHEET
Assets

STATEMENT

Income Tax
Expense

(1,881)

4-41

## (e) Calculation of taxes due:

Treatment revenue
Wages and salary expense
Utility expense
Rent expense
Depreciation expense
Chemical expense
Income before tax
Tax rate
Income tax expense

\$ 40,600
(23,580)
(1,240)
(860)
(400)
(150)
(8,100)
\$ 6,270
0.30
\$ 1,881

## 2. On the basis of the information available, Lewis appears to be a profitable

business. Net income for the month was \$6,270 \$1,881 (taxes), or \$4,389. With
treatment revenue of \$40,600, this results in a profit margin of \$4,389/\$40,600, or
approximately 11%.
ALTE R N ATE M U LTI - 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

Cash revenue
Accrual revenue: 50,000 sandwiches \$2

\$ 100,000
25,000
\$ 75,000
\$ 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
delivered to the vendors. Maries might consider using the cash method to account
for sales of sandwiches if there is a significant amount of uncertainty about the
collectibility of accounts receivable.

4-42

3.

## Income statement under the accrual basis:

MARIES CATERING
INCOME STATEMENT
FOR THE YEAR ENDED XX/XX/XX
Sales revenue
Cost of goods sold
Gross profit
Operating expenses:
Office salaries
Equipment depreciation
Truck depreciation
Total operating expenses
Net income
*Rent: \$800 12
Raw materials
Salaries and wages
Cost of goods sold
**\$10,000/10 years
***\$14,000/5 years

\$100,000
69,600*
\$ 30,400
\$ 12,000
1,000**
2,800***
\$ 15,800
\$ 14,600
\$ 9,600
25,000
35,000
\$69,600

LO 3,4

RECOGNITION

Expenses:
Salaries
Depreciation (c)
Rent (d)
Total expenses
Net income

## SUES AUDIO BOOK RENTALS

INCOME STATEMENTS
Year 1
\$ 21,000

Year 2
\$ 63,000

\$ 6,000
0
2,500
9,000
\$ 17,500
\$ 3,500

\$ 4,500
12,000
2,500
9,000
\$ 28,000
\$ 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
Less promotional portion

\$ 10,500
1,500
\$ 9,000 or \$4,500/year

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

c. Depreciation per year = \$5,000/2 = \$2,500/year
d. Rent per year = \$18,000/2 = \$9,000/year

4-43

4-44

## FINANCIAL ACCOUNTING SOLUTIONS MANUAL

LO 5,6

FINANCIAL STATEMENTS

BALANCE SHEET
Assets
a. Prepaid
Insurance

Liabilities

INCOME

Insurance Expense

Liabilities

INCOME

Depreciation
Expense
Warehouse

BALANCE SHEET
=

Liabilities

INCOME

d.

Liabilities
Interest Payable

INCOME

e.

Liabilities

375

Customer
Deposits

f.

Liabilities
Wages and
Salaries
Payable

g.

Liabilities
Income Taxes
Payable

STATEMENT

Freight Revenue

4,500

(4,500)

INCOME

Wages and
Salary
Expense

8,200

INCOME

STATEMENT

BALANCE SHEET
Assets

(375)

BALANCE SHEET
Assets

STATEMENT

Interest Expense

INCOME

(3,125)

BALANCE SHEET
Assets

STATEMENT

Depreciation
Expense
Truck Fleet

BALANCE SHEET
=

(150)

## Stockholders Equity + Revenues Expenses

c. Accumulated
Depreciation
Truck Fleet (3,125)

Assets

STATEMENT

b. Accumulated
Depreciation
Warehouse
(150)

Assets

(750)

(750)

BALANCE SHEET
Assets

STATEMENT

(8,200)

STATEMENT

9,237

Income Tax
Expense

(9,237)

## 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
Gas and oil expense
Maintenance expense
Wage and salary expense
Insurance expense
Depreciation on warehouse
Depreciation on truck fleet
Interest expense
Income before tax
Tax rate
Income tax expense
2.

\$ 170,170
(57,330)
(26,400)
(51,250)
(750)
(150)
(3,125)
(375)
\$ 30,790
0.30
\$
9,237

Financial statements:
(a)

## TENFOUR TRUCKING COMPANY

INCOME STATEMENT
FOR THE MONTH ENDED JANUARY 31, 2007
Freight revenue
Expenses:
Gas and oil
\$ 57,330
Maintenance
26,400
Wages and salaries
51,250
Insurance
750
Depreciationwarehouse
150
Depreciationtruck fleet
3,125
Interest
375
Income taxes
9,237
Net income
TENFOUR TRUCKING COMPANY
STATEMENT OF RETAINED EARNINGS
FOR THE MONTH ENDED JANUARY 31, 2007
Beginning balance, January 1, 2007

\$ 170,170

148,617
\$ 21,553

(b)

## Deduct: Cash dividends

Ending balance, January 31, 2007

\$ 40,470
21,553
\$ 62,023
20,000
\$ 42,023

4-45

4-46

(c)

## TENFOUR TRUCKING COMPANY

BALANCE SHEET
JANUARY 31, 2007

Assets
Current assets:
Cash
Accounts receivable
Prepaid insurance
Total current assets
Property, plant, and equipment:
Land
Warehouse
Less: Accumulated
depreciation
Truck fleet
Less: Accumulated
depreciation
Total property, plant, and
equipment
Total assets
Liabilities
Current liabilities:
Accounts payable
Notes payable
Interest payable
Customer deposits
Wages and salaries payable
Income tax payable
Total current liabilities
Total liabilities
Stockholders Equity
Capital stock
Retained earnings
Total stockholders equity
Total liabilities and stockholders
equity

\$ 27,340
41,500
17,250
\$ 86,090
\$ 20,000
\$ 40,000
21,750

18,250

\$ 240,000
115,625

124,375
162,625
\$ 248,715

\$ 32,880
50,000
4,875
1,500
8,200
9,237
\$ 106,692
\$ 106,692
\$ 100,000
42,023
142,023
\$ 248,715

4-47

## 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
current 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
measure of profitability for any company is the profit margin, which is net income
divided 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.

DECISION CASES

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
companies 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
companys total assets. The reason that this percentage is so small is because
customers in a store such as Finish Line usually pay with either cash or a credit
card.
3. In Foot Lockers annual report, Note 8, titled Other Current Assets includes Net
receivables 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
together represent only \$50,000,000/\$3,312,000,000, or 1.5% of total assets on this
date.

4-48

## 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
directly on the balance sheet or instead in one of the notes to the statements.

LO 3
1.

## DECISION CASE 4-2 READING AND INTERPRETING SEARS,

ROEBUCKS NOTESREVENUE RECOGNITION

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:

Sales revenue
Service contract revenue
Total revenue

Year 1
\$2,320*
60**
\$2,380

Year 2
\$
0
60
\$ 60

Year 3
\$ 0
60
\$ 60

Total
\$ 2,320
180
\$ 2,500

*\$2,500 \$180
**\$180/3 years
When a retailer sells a service contract, it receives cash and at the same time
incurs a liability to provide service in the future. Thus, on its balance sheet, it will
report a liability account for work to be performed under service contractsa form
of unearned revenue. This account tells the reader the amount of revenue to be
recognized 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.

4-49

LO 2,3,4
1.

## DECISION CASE 4-3 THE USE OF NET INCOME

AND CASH FLOW TO EVALUATE A COMPANY

DUKE INC.
STATEMENT OF CASH FLOWS
FOR THE YEAR ENDED DECEMBER 31, 2007
Operating Activities:
provided to clients
Cash paid for:
Salaries and wages
Supplies
Utilities
Rent
Net increase in cash

\$ 1,020,000*
\$ 440,000**
100,000
30,000
180,000***
\$

750,000
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 assumed
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
continue 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
generated from operations or the company is able to negotiate an extension of the
due date for the loan.

4-50

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
maintenance if it leases the equipment. Another relevant factor would be whether the
equipment 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.

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
increase in net income. Finally, an increase in the estimated useful life of the
automobiles will result in a decrease in the amount of depreciation expense and
thus an increase in net income.

4-51

## 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 revenuei.e., commissionsuntil July. Likewise,
deferring the recognition of the advertising bill as an expense until July also
violates the matching principle. Under the matching principle, this cost should be
recognized 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 increase 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
represent 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 depreciates assets from one period to the next.
3. Each of the three suggestions involves a question of ethics. All three involve an
attempt 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
trustworthiness of the company to accurately report its income, and each of the
three suggestions 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
reputation 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 reflect 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).

4-52

LO 4

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

The financial statements contain two major errors that prevent them from being in
accordance 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
Supplies expense
Depreciation expense
Revised net income (loss)

\$ 10,500
(15,500)
(5,000)
\$ (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,
particularly 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
information 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 operates.

## 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 Lockers 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.

4-53

## SOLUTION TO INTEGRATIVE PROBLEM

Part 1
1. Effects on the accounting equation are as follows:
BALANCE SHEET
Assets

a.

Liabilities
Salary and
Wages Payable

INCOME

4,000

BALANCE SHEET
Assets

Liabilities

Supplies
Expense

BALANCE SHEET
=

Liabilities

INCOME

Liabilities

INCOME

e. Extended
Warranty

Liabilities

INCOME

Liabilities

INCOME

Medical Services
Revenue

BALANCE SHEET
g.

STATEMENT

## Stockholders Equity + Revenues Expenses

f. Billings Receivable,
Net
16,000

Assets

STATEMENT

Extended Warranty
Expense
(3,000)

(3,000)

(10,000)

BALANCE SHEET
Assets

STATEMENT

Depreciation
Expense
Building

BALANCE SHEET
=

(30,000)

d. Accumulated
Depreciation
Building
(10,000)

Assets

STATEMENT

Depreciation
Expense
Automobiles

BALANCE SHEET
=

(64,347)

## Stockholders Equity + Revenues Expenses

c. Accumulated
Depreciation
Automobiles (30,000)

Assets

STATEMENT

## Stockholders Equity + Revenues Expenses

b. Medical
Supplies (64,347)

Assets

Salary and
Wages Expense (4,000)

INCOME

STATEMENT

Liabilities
Interest Payable

INCOME

16,000

STATEMENT

3,000

Interest

4-54

Expense

3,000

2.

## MOUNTAIN HOME HEALTH INC.

INCOME STATEMENT
FOR THE YEAR ENDED DECEMBER 31, 2006
Revenues:
Medical services revenue
Expenses:
Salary and wages expense
Supplies expense
Gasoline expense
Utilities expense
Interest expense
Depreciation expenseautomobiles
Depreciation expensebuilding
Extended warranty contract expense

\$ 566,000
\$292,000
64,347
137,500
12,000
3,000
30,000
10,000
3,000
551,847
\$ 14,153

Net income
MOUNTAIN HOME HEALTH INC.
RETAINED EARNINGS STATEMENT
FOR THE YEAR ENDED DECEMBER 31, 2006
Beginning balance
Deduct: Dividends
Ending balance

\$ 99,900
14,153
(10,000)
\$ 104,053

4-55

3.

## MOUNTAIN HOME HEALTH INC.

BALANCE SHEET
AS OF DECEMBER 31, 2006
Assets
Current assets:
Cash
Billings receivable, net
Medical supplies
Total current assets
Property, plant, and equipment:
Building
Less: Accumulated depreciation
Total assets
Liabilities and Stockholders Equity
Current liabilities:
Accounts payable
Interest payable
Salary and wages payable
Dividend payable
Total current liabilities
Long-term liabilities:
Mortgage payable
Total liabilities
Stockholders Equity
Capital stock
Retained earnings
Total stockholders equity
Total liabilities and stockholders equity

\$ 77,400
167,000
8,653
\$ 253,053
\$ 200,000
(60,000)

140,000
\$ 393,053

\$ 22,000
3,000
4,000
10,000
\$ 39,000
100,000
\$ 139,000
\$ 100,000
50,000
104,053
254,053
\$ 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
adjustment for wages and salaries, and interest, result in decreases in income in
the current period with a delay in the outflow of cash until a later period. Similarly,
the adjustment 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.

4-56

## 6. Supply of cash needed:

Salaries: \$800 per day 7 days per week 7 weeks
Supplies: \$1,500 per week 7 weeks
Gasoline: \$375 per day 7 days per week 7 weeks
Supply of cash needed for 7 weeks

=
=
=
=

\$ 39,200
10,500
18,375
\$ 68,075