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Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings

Chapter 04
Adjustments, Financial Statements, and
the Quality of Earnings
ANSWERS TO MULTIPLE CHOICE
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.

c
b
b
a
b
c
c
d
c
a

EXERCISES
E44.
Req. 1
Prepaid Insurance is a deferred expense that needs to be adjusted each period for the
amount used during the period.
The amount of expense is computed as follows: $3,600 x 3/24 = $450 used
Adjusting entry:
Insurance expense (+E, SE) .....................................
Prepaid insurance (A) ....................................

450
450

Req. 2
Shipping Supplies is a deferred expense that needs to be adjusted at the end of the
period for the amount of supplies used during the period.
The amount is computed as follows: Beginning balance
Supplies purchased
Supplies on hand at end
Supplies used
Adjusting entry:
Shipping supplies expense (+E, SE) ........................
Shipping supplies (A) .....................................

4-1

$11,000
60,000
(20,000)
$51,000
51,000
51,000

Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings

Req. 3
Prepaid Insurance
10/1 3,600
AJE 450
End.
3,150

Insurance Expense
AJE
End.

Shipping Supplies
Beg. 11,000
Purch. 60,000 AJE 51,000
End. 20,000

450
450

Shipping Supplies Expense


AJE 51,000
End. 51,000

2011 Income statement:


Insurance expense
$ 450
Shipping supplies expense $51,000

Req. 4
2011 Balance sheet:
Prepaid insurance $ 3,150
Shipping supplies $20,000

E45.

Transaction Assets
E43 (a)
NE
E43 (b)
+2,000
E44 (a)
450
E44 (b)
51,000

Balance Sheet
Stockholders
Liabilities
Equity
+7,000
7,000
NE
+2,000
NE
450
NE
51,000

Income Statement
Net
Revenues Expenses Income
NE
+7,000
7,000
+2,000
NE
+2,000
NE
+450
450
NE
+51,000
51,000

E46.
Req. 1
a.
b.
c.
d.
e.
f.
g.

Accrued expense
Deferred expense
Accrued revenue
Deferred expense
Deferred expense
Deferred revenue
Accrued revenue

Req. 2
a.
Wages expense (+E, SE) ........................... 2,700
Wages payable (+L) ...........................
4-2

Computations
Given
2,700

Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings

b.

c.

Office supplies expense (+E, SE) ...............


Office supplies (A) ............................

675
675

Rent receivable (+A) ..................................... 1,120


Rent revenue (+R, +SE) .....................

1,120

$450 + $500
- $275 = $675 used
$560 x 2 months
= $1,120 earned

d.

Depreciation expense (+E, SE) .................. 12,100


12,100
Accumulated depreciation (+XA, A)

Given

e.

Insurance expense (+E, SE).......................


Prepaid insurance (A) .......................

$2,400 x 6/24 =
$600 used

f.

600
600

Unearned rent revenue (L) ......................... 3,200


Rent revenue (+R, +SE) .....................

g.

Repair accounts receivable (+A) ..................


Repair shop revenue (+R, +SE) .........

3,200

800

$9,600 x 2/6 =
$3,200 earned
Given

800

E410.

a.

Independent Situations
Accrued wages, unrecorded and unpaid at
year-end, $400 (example).

Debit
Code Amount
N
400

Credit
Code Amount
G
400

b.

Service revenue earned but not yet


collected at year-end, $600.

600

600

c.

Dividends declared and paid during the


year, $900.

900

900

d.

Office Supplies on hand during the year,


$400; supplies on hand at year-end, $160.

240

240

e.

Service revenue collected in advance,


$800.

800

800

f.

Depreciation expense for the year, $1,000.

1,000

1,000

g.

At year-end, interest on note payable not


yet recorded or paid, $220.

220

220

h.

Balance at year-end in Service Revenue


account, $56,000. Give the closing entry at
year-end.

56,000

56,000

i.

Balance at year-end in Interest Expense


account, $460. Give the closing entry at

460

460

4-3

Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings

year-end.

E411.
Selected Balance Sheet Amounts at December 31, 2012
Assets:
Equipment (recorded at cost per cost principle)
Accumulated depreciation (for one year, as given)
Net book value of equipment (difference)

$12,000
(1,200)
10,800

Office supplies (on hand, as given)

400

Prepaid insurance (remaining coverage, $600 x 18/24 months)

450

Selected Income Statement Amounts for the Year Ended December 31, 2012
Expenses:
Depreciation expense (for one year, as given)
$ 1,200
Office supplies expense (used, $1,600 - $400 on hand)
1,200
Insurance expense (for 6 months, $600 x 6/24 months)
150

E413.
Req. 1

(a)

Cash paid on accrued income taxes payable.

(b)

Accrual of additional income tax expense.

(c)

Cash paid on dividends payable.

(d)

Amount of dividends declared for the period.

(e)

Cash paid on accrued interest payable.

(f)

Accrual of additional interest expense.

Req. 2 Computations:
(a)
Beg. Bal. +
accrued income taxes
$135
+
656

cash paid
?
?

=
=
=

(c)
Beg. Bal.
$110

dividends declared
456

cash paid
?
?

=
=
=

accrued interest expense


?

cash paid
1,127

=
=

+
+

(f)
Beg. Bal. +
$140
+

4-4

End. bal.
$79
$712 paid

End. bal.
$118
$448 paid

End. bal.
$150

Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings

4-5

$1,137 accrued

Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings

E415.

Items
Balances reported
Additional adjustments:
a. Wages
b. Depreciation
c. Rent revenue
Adjusted balances
d. Income taxes
Correct balances

Net
Income
$60,000
(39,000)
(17,000)
3,200
7,200
(2,160)
$ 5,040

Total
Assets
$170,000

Total
Liabilities
$80,000

Stockholders
Equity
$90,000

39,000

(39,000)
(17,000)
3,200
37,200
(2,160)
$35,040

(17,000)
153,000
$153,000

(3,200)
115,800
2,160
$117,960

Computations:
a.
Given, $39,000 accrued and unpaid.
b.
Given, $17,000 depreciation expense.
c.
$9,600 x 1/3 = $3,200 rent revenue earned. The remaining $6,400 in unearned
revenue is a liability for two months of occupancy "owed'' to the renter.
d.
$7,200 income before taxes x 30% = $2,160.

E416.
Req. 1
a.

b.

c.

Rent receivable (+A) ...................................


Revenues (rent) (+R, +SE) ..................

2,500

Expenses (depreciation) (+E, SE) ............


Accumulated depreciation (+XA, A) ...

4,500

Income tax expense (+E, SE) ...................


Income taxes payable (+L) ..................

5,100

2,500

4,500

5,100

Req. 2
Effects of
Adjusting
Entries

As
Prepared
Income statement:
Revenues
Expenses
Income tax expense
Net income

$97,000
(73,000)
$24,000

Balance Sheet:

4-6

a
b
c

$2,500
(4,500)
(5,100)
(7,100)

Corrected
Amounts
$99,500
(77,500)
(5,100)
$16,900

Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings

Assets
Cash
Accounts receivable
Rent receivable
Equipment
Accumulated depreciation
Liabilities
Accounts payable
Income taxes payable
Stockholders' Equity
Contributed capital
Retained earnings

$20,000
22,000
50,000
(10,000)
$82,000

2,500

(4,500)
(2,000)

$20,000
22,000
2,500
50,000
(14,500)
$80,000

5,100

$10,000
5,100

(7,100)
(2,000)

40,000
24,900
$80,000

$10,000
c

40,000
32,000
$82,000

E420.
Req. 1
The purposes of closing the books at the end of the accounting period are to:
Transfer the balance in the temporary accounts to a permanent account
(Retained Earnings).
Create a zero balance in each of the temporary accounts for accumulation of
activities in the next accounting period.

Req. 2
Revenues (R) ...........................................................
Expenses ($32 + $4 + $8 + $5 + $9) (E) ........
Retained earnings (+SE) .................................

PROBLEMS
P42.
Req. 1
a.

Deferred revenue

e.

Deferred expense

b.

Accrued expense

f.

Accrued revenue

c.

Deferred expense

g.

Accrued expense

d.

Deferred revenue

h.

Accrued expense

4-7

84
58
26

Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings

Req. 2
a.

b.

c.

d.

e.

f.

g.

h.

Unearned rent revenue (L) .........................................


Rent revenue (+R, +SE).....................................
($8,400 6 months = $1,400 per month x 4 months)

5,600

Interest expense (+E, SE) ..........................................


Interest payable (+L) ............................................
($18,000 x .12 x 3/12)

540

Depreciation expense (+E, SE) ..................................


Accumulated depreciation (+XA, A) ..................

2,500

Unearned service revenue (L) ....................................


Service revenue (+R, +SE) .................................
($3,000 x 2/12)

500

5,600

540

2,500

500

1,500
Insurance expense (+E, SE) ......................................
Prepaid insurance (A) .....................................
($9,000 12 months = $750 per month x 2 months of coverage)
Accounts receivable (+A) .............................................
Service revenue (+R, +SE) ................................

4,000

Wage expense (+E, SE).............................................


Wages payable (+L) ...........................................

14,000

Property tax expense (+E, SE) ...................................


Property tax payable (+L) .....................................

500

4-8

1,500

4,000

14,000

500

Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings

P43.
Req. 1
a.

Deferred expense

e.

Accrued revenue

b.

Deferred expense

f.

Deferred expense

c.

Accrued expense

g.

Accrued expense

d.

Accrued expense

h.

Accrued expense

Req. 2
a.

b.

c.

d.

e.

f.

g.

h.

Depreciation expense (+E, SE) ..................................


Accumulated depreciation (+XA, A) ..................

4,000
4,000

1,150
Supplies expense (+E, SE) ........................................
Supplies (A)......................................................
(Beg. Inventory of $400 + Purchases $1,000 Ending Inventory $250)
Repairs expense (+E, SE)..........................................
Accounts payable (+L) .......................................

1,200

Property tax expense (+E, SE) ...................................


Property tax payable (+L) .....................................

1,500

Accounts receivable (+A) .............................................


Service revenue (+R, +SE) ................................

6,000

Insurance expense (+E, SE) ......................................


Prepaid insurance (A) .....................................
($1,200 36 months x 6 months of coverage)

200

Interest expense (+E, SE) ..........................................


Interest payable (+L) ............................................
($11,000 x .14 x 3/12)

385

1,150

1,200

1,500

6,000

200

385

8,270
Income tax expense (+E, SE) ....................................
Income tax payable (+L).......................................
8,270
To accrue income tax expense incurred but not paid:
Income before adjustments (given)
$30,000
Effect of adjustments (a) through (g)
(2,435) ($4,000$1,150$1,200
Income before income taxes
27,565 $1,500+$6,000$200$385)
Income tax rate
x 30%
Income tax expense
$ 8,270 (rounded)

4-9

Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings

P47.
Req. 1
December 31, 2011, Adjusting Entries:
(a)

(b)

(c)

(d)

(e)

Supplies expense (+E, SE) ......................................


Supplies (A) ..................................................

400

Insurance expense (+E, SE) ....................................


Prepaid insurance (A) ...................................

400

Depreciation expense (+E, SE) ...............................


Accumulated depreciation (+XA, A) ..............

4,200

Wages expense (+E, SE) .........................................


Wages payable (+L) ........................................

720

Income tax expense (+E, SE) ..................................


Income taxes payable (+L) .............................

5,880

400

400

4,200

720

5,880

Req. 2
ELLIS, INC.
Income Statement
For the Year Ended December 31, 2011
Operating Revenue:
Service revenue

$61,600

Operating Expenses:
Supplies expense ($640 - $240)
Insurance expense
Depreciation expense
Wages expense
Remaining expenses (not detailed)
Total expenses
Operating Income
Income tax expense
Net Income

400
400
4,200
720
33,360
39,080
22,520
5,880
$16,640

Earnings per share ($16,640 5,000 shares)

4-10

$3.33

Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings

P47. (continued)
Req. 2 (continued)
ELLIS, INC.
Balance Sheet
At December 31, 2011
Assets
Current Assets:
Cash
Accounts receivable
Supplies
Prepaid insurance
Total current assets
Service trucks
Accumulated depreciation
Other assets (not detailed)

Total assets

Liabilities and Stockholders Equity


Current Liabilities:
Accounts payable
$ 2,400
Wages payable
720
Income taxes payable
5,880
Total current liabilities
9,000
Note payable, long term
16,000
Total liabilities
25,000

$46,000
10,400
240
400
57,040
16,000
(13,800)

Stockholders' Equity
Contributed capital
Retained earnings*
Total stockholders' equity
Total liabilities and
stockholders' equity

8,960

$68,200

20,560
22,640
43,200
$68,200

*Unadjusted balance, $6,000 + Net income, $16,640 = Ending balance, $22,640.

Req. 3
December 31, 2011, Closing Entry:
Service revenue (R) ..................................................
Retained earnings (+SE) ................................
Supplies expense (E) ....................................
Insurance expense (E) ..................................
Depreciation expense (E) .............................
Wages expense (E) ......................................
Remaining expenses (not detailed) (E) ..........
Income tax expense (E) ................................

4-11

61,600
16,640
400
400
4,200
720
33,360
5,880

Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings

COMPREHENSIVE PROBLEMS
COMP41.
Req. 1, 2, 3, and 5 T-accounts (in thousands)
Cash
Bal.
4 b
a
12 e
c
156 g
d
4 h
f
34 k
Bal. 53

Bal.
b
Bal.

12
91
13
19
22

Accounts Receivable
Bal.
7
c
52 f
34

Bal.

Land
0
12
12

25

Bal.
i

Bal.

Other Assets
Bal.
5
g
13

21

18

Accumulated
Depreciation
Bal.
8
m
8
Bal. 16

Equipment
Bal. 78
Bal.

Supplies
16
23 l

78

Accounts Payable
Bal.
0
h
19 e
20
i
23
Bal. 24

Income Tax Payable


Bal. 0
p
10

Wages Payable
Bal.
0
o
16
Bal. 16

Interest Payable
Bal.
0
n
1
Bal.
1

LT Notes Payable
Bal.
0
a
12
Bal. 12

Contributed
Capital
Bal. 85
d
4

Retained
Earnings
Bal.
22
CE
Bal.

Bal.

18

Bal.
Depreciation
Expense
Bal.
0
m
8 CE
Bal.
0

89

17
41
36

Income Tax
Expense
Bal.
0
p
10 CE
10
Bal.
0

4-12

Bal.

CE

10

Service
Revenue
Bal.
0
c
208
208
Bal.
0

Interest
Expense
Bal.
0
n
1 CE
Bal.
0

Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings

Supplies
Expense
Bal.
0
l
21 CE
Bal.
0

21

Wages
Expense
Bal.
0
o
16 CE
Bal.
0

16

Req. 2
a. Cash (+A) ..........................................................
Notes payable (+L) ..................................
b.

c.

d.

e.

f.

g.

h.

i.

Remaining
Expenses
Bal.
0
e
111 CE 111
Bal.
0

12,000
12,000

Land (+A)...........................................................
Cash (A) ................................................

12,000

Cash (+A) ..........................................................


Accounts receivable (+A)...................................
Service revenue (+R, +SE) ......................

156,000
52,000

Cash (+A) ..........................................................


Contributed capital (+SE) ........................

4,000

Remaining expenses (+E, SE).........................


Accounts payable (+L) .............................
Cash (A) ................................................

111,000

Cash (+A) ..........................................................


Accounts receivable (A) .........................

34,000

Other assets (+A) ..............................................


Cash (A) ................................................

13,000

Accounts payable (L) .......................................


Cash (A) ................................................

19,000

Supplies (+A) .....................................................


Accounts payable (+L) .............................

23,000

j.

No entry required; no revenue earned in 2012.

k.

Retained earnings (SE) ...................................


Cash (A) ................................................

4-13

12,000

208,000

4,000

20,000
91,000

34,000

13,000

19,000

23,000

22,000
22,000

Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings

COMP41. (continued)
Req. 3
l.

m.

n.

o.

p.

Supplies expense (+E, SE) ..............................


Supplies (A) ............................................
($39,000 in account $18,000 at year end)

21,000

Depreciation expense (+E, SE) .......................


Accumulated depreciation (+XA, A) ........

8,000

Interest expense (+E, SE) ...............................


Interest payable (+L) ................................
($12,000 x .10 x 10/12)

1,000

Wages expense (+E, SE) ................................


Wages payable (+L) .................................

16,000

Income tax expense (+E, SE) ..........................


Income taxes payable (+L) .......................

10,000

21,000

8,000

1,000

16,000

10,000

Req. 4

H & H TOOL, INC.


Income Statement
For the Year Ended December 31, 2012
Operating Revenues:
Service revenue
Operating Expenses:
Depreciation expense
Supplies expense
Wages expenses
Remaining expenses
Total operating expenses
Operating Income
Other Item:
Interest expense
Pretax income
Income tax expense
Net Income
Earnings per share
[$41,000 89,000 shares all year]

4-14

$208,000
8,000
21,000
16,000
111,000
156,000
52,000
1,000
51,000
10,000
$41,000
$0.46

Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings

COMP41. (continued)

H & H TOOL, INC.


Statement of Stockholders' Equity
For the Year Ended December 31, 2012

Balance, January 1, 2012


Additional stock issuance
Net income
Dividends declared
Balance, December 31, 2012

Contributed
Capital
$85,000
4,000

$89,000

Retained
Earnings
$ 17,000
41,000
(22,000)
$36,000

Total
Stockholders'
Equity
$102,000
4,000
41,000
(22,000)
$125,000

H & H TOOL, INC.


Balance Sheet
At December 31, 2012
Assets
Current Assets:
Cash
Accounts receivable
Supplies
Total current assets
Land
Equipment
Less: Accumulated deprec.
Other assets

$ 53,000
25,000
18,000
96,000
12,000
78,000
(16,000)
18,000

Total assets

$188,000

Liabilities and Stockholders Equity


Current Liabilities:
Accounts payable
$ 24,000
Interest payable
1,000
Wages payable
16,000
Income taxes payable
10,000
Total current liabilities
51,000
Notes payable
12,000
Total liabilities
63,000
Stockholders' Equity:
Contributed capital
89,000
Retained earnings
36,000
Total stockholders'
equity
125,000
Total liabilities and
stockholders' equity
$188,000

4-15

Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings

COMP41. (continued)

H & H TOOL, INC.


Statement of Cash Flows
For the Year Ended December 31, 2012
Cash from Operating Activities:
Cash collected from customers (c + f)
Cash paid to suppliers and employees (e +h)
Cash provided by operations

$190,000
(110,000)
80,000

Cash from Investing Activities:


Purchase of land (b)
Purchase of other assets (g)
Cash used for investing activities

(12,000)
(13,000)
(25,000)

Cash from Financing Activities:


Borrowing from bank (a)
Issuance of stock (d)
Payment of dividends (k)
Cash used for financing activities
Change in cash
Beginning cash balance, January 1, 2012
Ending cash balance, December 31, 2012

12,000
4,000
(22,000)
(6,000)
49,000
4,000
$ 53,000

Req. 5
December 31, 2012, Closing Entry
Service revenue (R) .........................................
Retained earnings (+SE) .........................
Depreciation expense (E) ......................
Interest expense (E) ..............................
Supplies expense (E) .............................
Wages expense (E) ...............................
Remaining expenses (E) .......................
Income tax expense (E) .........................

4-16

208,000
41,000
8,000
1,000
21,000
16,000
111,000
10,000

Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings

COMP41. (continued)
Req. 6
(a)

Current ratio = Current assets Current liabilities


= $96,000 $51,000
= 1.88
This suggests that H & H Tool, Inc., has sufficient current assets to pay current
liabilities.

(b)

Total asset turnover = Sales Average total assets


= $208,000 [($102,000 + $188,000) 2]
= $208,000 $145,000
= 1.43
This suggests that H & H Tool, Inc., generated $1.43 for every dollar of assets.

(c)

Net profit margin

= Net income Sales


= $41,000 $208,000
= 0.197 or 19.7%

This suggests that H & H Tool, Inc., earns $0.197 for every dollar in sales that it
generates.
For all of the ratios, a comparison across time and a comparison against an
industry average or competitors will need to be analyzed to determine how liquid
(current ratio) the company is and how efficient (total asset turnover) and how
effective (net profit margin) H & H Tools management is.

CASES AND PROJECTS


CP46.
Transaction (a):
1.

This transaction will affect Careys financial statements for 14 years (from 2011 to
2024) in conformity with the matching principle. [$14,000 $1,000 per year = 14
years]

2. Income statement:
Depreciation expense, as given

$1,000 each year

3. Balance sheet at December 31, 2013:


Assets:

4-17

Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings

Office equipment
Less: Accumulated depreciation*
Net book (carrying) value
*$1,000 x 3 years = $3,000.

$14,000
3,000
$11,000

4. An adjusting entry each year over the life of the asset would be recorded to reflect
the allocation of the cost of the asset when used to generate revenues:
1,000
Depreciation expense (+E, SE) . . . . . . . .
1,000
Accumulated depreciation (+XA, A) .

Transaction (b):
1. This transaction will affect Careys financial statements for 2 years--2013 and 2014-because four months rent revenue was earned in 2013, and two months' rent
revenue will be earned in 2014.
2. The 2013 income statement should report rent revenue earned of $20,000 ($30,000
x 4/6). Occupancy was provided for only 4 months in 2013. This is in conformity
with the revenue principle.
3. This transaction created a $10,000 liability ($30,000 - $20,000 = $10,000) as of
December 31, 2013, because at that date Carey "owes'' the renter two more
months' occupancy for which it has already collected the cash.
4. Yes, an adjusting entry must be made to (a) increase the Rent Revenue account by
$10,000 for two months rent earned in 2014 and (b) to decrease the liability to $0
representing no future occupancy owed (in conformity with the revenue principle).
December 31, 2014--Adjusting entry:
Unearned Rent Revenue (L) ......................... 10,000
Rent Revenue (+R, +SE) .......................
10,000

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Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings

CP46. (continued)
Transaction (c):
1. This transaction will directly affect Careys financial statements for two years, with
the expense incurred in 2013 and the cash payment in 2014.
2. The $7,500 should be reported as wage expense in the 2013 income statement and
as a liability on the 2013 balance sheet. On January 5, 2014, the liability will be
paid. Therefore, the 2014 balance sheet will reflect a reduced cash balance and
reduced liability balance. The transaction will not directly affect the 2014 income
statement (unless the adjusting entry was not made).
3. Yes, an adjusting entry must be made to (a) record the $7,500 as an expense in
2013 (matching principle) and (b) to record the liability which will be paid in 2014.
December 31, 2013--Adjusting entry:
Wage expense (+E, SE) ...............................
7,500
Wages payable (+L) ..............................
7,500
Note: On January 5, 2014, the liability, Wages Payable, of $7,500 will be paid. Wage
expense for 2014 will not include this $7,500. The 2014 related entry will debit
(decrease) Wages Payable, and credit (decrease) Cash, $7,500.
Transaction (d):
1. Yes, service revenue of $45,000 (i.e., $60,000 x 3/4) should be recorded as earned
by Carey in conformity with the revenue principle. Service revenue is recognized as
the service is performed.
2. Recognition of revenue earned but not collected by the end of 2013 requires an
adjusting entry. This adjusting entry is necessary to (a) record the revenue earned
(to be reported on the 2013 income statement) and (b) record the related account
receivable (an asset to be reported on the 2013 balance sheet). The adjusting entry
on December 31, 2013 is:
Accounts receivable (+A)............................................ 45,000
Service revenue (+R, +SE) ..............................
45,000
($60,000 total price x 3/4 completed)
3. February 15, 2014--Completion of the last phase of the service contract and cash
collected in full:
Cash (+A) .................................................................. 60,000
Accounts receivable (A) .................................
45,000
Service revenue (+R, +SE) ..............................
15,000

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Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings

CP47.
Req. 1
Adjusting entries:
(a) Expenses (insurance) (+E, SE) .......................................
Prepaid insurance (A) ...........................................
To adjust for expired insurance.
(b)

(c)

(d)

(e)

(f)

1
1

Rent receivable (+A) .........................................................


Revenues (rent) (+R, +SE) ......................................
To adjust for rent revenue earned but not yet collected.

Expenses (depreciation) (+E, SE) ...................................


Accumulated depreciation (+XA, A) .......................
To adjust for annual depreciation.

11

Expenses (wages) (+E, SE) ............................................


Wages payable (+L) ................................................
To adjust for wages earned but not recorded or paid.

Income tax expense (+E, SE) .........................................


Income taxes payable (+L) ......................................
To adjust for income tax expense.

Unearned rent revenue (L) ...............................................


Revenues (rent) (+R, +SE) ......................................
To adjust for rent revenue collected but unearned.

11

Req. 2
Closing entry (from the adjusted trial balance):
Revenues (R) ...................................................................
Retained earnings (+SE) ..............................................
Expenses (E)...............................................................
Income tax expense (E) ..............................................
To close the temporary accounts to Retained Earnings for
2011.

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103
15
83
5

Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings

CP47. (continued)
Req. 3
(a) Shares outstanding: 1,000 shares (given) no change all year.
(b) Interest expense: $20 thousand x .10 = $2 thousand.
(c) Ending balance in retained earnings:
Unadjusted balance, $(3,000) + Net income, $15,000 = $12,000.
(d) Average income tax rate: $5,000 income tax expense ($103,000 revenues $83,000 total expenses) = 25%.
(e) Rent Receivable -- report on the balance sheet as an asset (probably current).
Unearned Rent Revenue -- report on the balance sheet as a liability probably
(current) for future occupancy "owed''.
(f) Net income of $15,000 was computed on the basis of accrual accounting concepts.
Revenue is recognized when earned and expenses recorded when incurred
regardless of the timing of the respective cash flows. Cash inflows, in addition to
certain revenues, were from numerous sources such as the issuance of capital
stock, borrowing, and revenue collected in advance. Similarly, cash outflows were,
in addition to certain expenses, due to numerous transactions such as the purchase
of operational and other assets, prepaid insurance, and dividends to stockholders.
(g) EPS: $15,000 1,000 shares (per (a) above) =$15.00 per share.
(h) Selling price per share: $30,000 contributed capital 1,000 shares = $30 per
share.
(i) The prepaid insurance account reflected a $2,000 balance before the adjustment
(decrease) of $1,000. Therefore, it appears that the policy premium was paid on
January 1, 2011, and it was prepaid for two years (2011 and 2012). Other
possibilities might be (a) a 12-month policy purchased on July 1, 2011, or (b) a 2month policy purchased on December 1, 2011. In any case, one-half of the
premium has expired.
(j) Net profit margin: $15,000 net income $103,000 revenues = 0.146 (14.6%).

4-21

Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings

CP48.
Req. 1
CRYSTALS DAY SPA AND SALON, INC.
Income Statement
For the Year Ended December 31, 2012

Items
Revenues:
Spa fees
Expenses:
Office rent
Utilities
Telephone
Salaries
Supplies
Miscellaneous
Depreciation
Total expenses
Net income
*

**

Cash
Basis Per
Crystals
Statement

Explanation of Changes

Corrected
Basis

$1,215,000 See * below.

$1,102,000

130,000
43,600
12,200
562,000
31,900
12,400
0
792,100
$ 422,900

120,000
43,600
11,800
563,500
29,825
12,400
20,500
801,625
$ 300,375

Exclude rent for Jan. 2013 ($130,000 13) (g)


No change
See ** below.
Add December 2012 salary ($18,000 12) (e)
See *** below.
No change
Given for 2012 (c)

Cash collected for spa fees


Fees earned in prior years (a)
Fees earned in 2012 but not yet collected (b)
Fees earned in 2012

$1,215,000
-142,000
+ 29,000
$1,102,000

$12,200 telephone paid + $1,400 December 2012 telephone bill - $1,800


December 2011 bill paid in 2012 = $11,800

***
Beg.
Purchases
End.

Supplies (d)
3,125
31,900 29,825
5,200

Used

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Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings

CP48. (continued)
Req. 2
Memo to Crystal Mullinex should include the following:
(1) Net income was overstated by $122,525 because of inappropriate recognition of
revenue (overstated by $113,000) and expenses (understated by $9,525).
Revenue should be recognized when earned, not when the cash is collected.
Similarly, expenses should be matched against revenue in the period when the
services or materials were used (including depreciation expense).
(2) Some other items the parties should consider in the pricing decision:
(a) A correct balance sheet at December 31, 2012.
(b) Collectability of any receivables (if they are to be sold with the business).
(c) Any liabilities of the spa to be assumed by the purchaser.
(d) Current employees -- how will they be affected?
(e) Adequacy of the rented space -- is there a long-term noncancellable lease?
(f) Characteristics of Crystals spa practices.
(g) Expected future cash flows of the business. What is the present value of
those expectations?

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