Chapter-4 Income Measurement and Accrual Accounting

CHAPTER 4
Income Measurement and

Accrual Accounting
OVERVIEW OF EXERCISES, PROBLEMS, AND CASES
Estimated
Time in
Learning Objective Exercises Minutes Level
1. Explain the significance of recognition and measurement 18* 20 Diff

in the preparation and use of financial statements.
2. Explain the differences between the cash and accrual 18* 20 Diff
bases of accounting.
3. Describe the revenue recognition principle and explain its 1 10 Easy

application in various situations. 18* 20 Diff
4. Describe the matching principle and the various methods 2 10 Mod

for recognizing expenses. 19* 15 Mod
20* 15 Mod
5. Identify the four major types of adjustments and determine 3 10 Easy

their effect on the accounting equation. 4 10 Easy
5 20 Easy
6 20 Easy
7 15 Easy
8 15 Easy
9 15 Easy
10 15 Mod
11 15 Easy
12 15 Easy
13 15 Easy
14 15 Easy
15 10 Mod
16 15 Mod
19* 15 Mod
20* 15 Mod
6. Explain the steps in the accounting cycle and the significance 17 5 Easy
of each step.
*Exercise, problem, or case covers two or more learning objectives

Level = Difficulty levels: Easy; Moderate (Mod); Difficult (Diff)
4-1
4-2 FINANCIAL ACCOUNTING SOLUTIONS MANUAL
Problems Estimated
and Time in
Learning Objective Alternates Minutes Level
1. Explain the significance of recognition and measurement

in the preparation and use of financial statements.
2. Explain the differences between the cash and accrual 8* 25 Mod

bases of accounting.
3. Describe the revenue recognition principle and explain its

application in various situations. 8* 25 Mod
9* 25 Diff
4. Describe the matching principle and the various methods 8* 25 Mod

for recognizing expenses. 9* 25 Diff
5. Identify the four major types of adjustments and determine 1 20 Mod

their effect on the accounting equation. 2 20 Mod
3 20 Mod
4 15 Mod
5 20 Mod
6 25 Mod
7 15 Mod
10* 60 Mod
6. Explain the steps in the accounting cycle and the significance 10* 90 Mod
of each step.

# Original problem only
**Alternate problem only
CHAPTER 4 INCOME MEASUREMENT AND ACCRUAL ACCOUNTING 4-3
Estimated
Time in
Learning Objective Cases Minutes Level
1. Explain the significance of recognition and measurement

in the preparation and use of financial statements. 1* 30 Mod
2. Explain the differences between the cash and accrual 1* 30 Mod

bases of accounting. 3* 30 Mod
5* 60 Diff
3. Describe the revenue recognition principle and explain its 1* 30 Mod

application in various situations. 2 30 Mod
3* 30 Mod
5* 60 Diff
4. Describe the matching principle and the various methods

for recognizing expenses. 3* 30 Mod
4 25 Mod
5* 60 Diff
6 45 Mod
5. Identify the four major types of adjustments and determine 5* 60 Diff

their effect on the accounting equation.
6. Explain the steps in the accounting cycle and the significance

of each step.

QUESTIONS
1. The accountant cannot show a stockholder or other user the company’s assets,
such as cash and buildings. Instead, what the user sees is a representation or
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 banker’s needs.
The accountant, however, may be reluctant to present the current value of the
asset on the balance sheet because of the difficulty in measuring the value of the
asset with any degree of reliability. The amount paid for the asset—that is, its
historical cost—may be more reliable, although not as relevant to the banker’s
decision.
3. The realtor will recognize revenue from the sale of the home on July 8 if the cash
basis is used because this is the date cash is received. Revenue will be
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.
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 month’s 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.
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 EXERCISE 4-1 REVENUE RECOGNITION
Cash collected at toll booth $ 3,000,000

Passes redeemed 1,700,000
Revenue recognized $ 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 EXERCISE 4-3 ACCRUALS AND DEFERRALS
1. AL 5. DE
2. DR 6. DR
3. AA 7. AL
4. DE 8. AA
LO 5 EXERCISE 4-4 OFFICE SUPPLIES
To record office supplies used.
BALANCE SHEET INCOME STATEMENT

Assets = Liabilities + Stockholders’ Equity + Revenues – Expenses
5/31 Office Supplies Office Supplies

on Hand (1,630) Expense (1,630)
(1,450 + 1,100
– 920)
Net income for the month of May would be overstated by $1,630 if this adjustment were
not recognized, because expenses would be understated.
LO 5 EXERCISE 4-5 PREPAID RENT—QUARTERLY

ADJUSTMENTS
1. $12,000/6 months = $2,000 per month.
2. To record prepayment of six months’ rent on September 1.

9/1 Prepaid
Rent 12,000
Cash (12,000)
3. To record one month of rent expense on September 30.

9/30 Prepaid Rent Expense (2,000)

Rent (2,000)
4. If the accountant forgot to record an adjustment on December 31, net income for
the year would be overstated by $6,000 ($2,000 per month  3 months).
LO 5 EXERCISE 4-6 DEPRECIATION
1. To record purchase of combine on July 1.

7/1 Equipment 100,000

Cash (100,000)
2. Purchase price $ 100,000

Less: Estimated salvage value (16,000)
Depreciable cost $ 84,000
3. Monthly depreciation = depreciable cost/estimated life = $84,000/84 months =

$1,000/month.
4. To record one month’s depreciation expense on July 31.

7/31 Accumulated Depreciation

Depreciation (1,000) Expense (1,000)
5. Equipment $ 100,000
Less: Accumulated depreciation (6 months ×
$1,000/month) (6,000)
Carrying value $ 94,000
LO 5 EXERCISE 4-7 PREPAID INSURANCE—ANNUAL

ADJUSTMENTS
1. Monthly cost: $72,000/24 months = $3,000.
2. To record purchase of 24-month policy on April 1.

4/1 Prepaid
Insurance 72,000
Cash (72,000)
EXERCISE 4-7 (Concluded)
3. To record expiration of nine months of insurance on December 31.

12/31 Prepaid Insurance

Insurance (27,000) Expense
(27,000)
4. Net income will be overstated by $27,000 if the accountant forgets to record an

adjustment to recognize an expense.
LO 5 EXERCISE 4-8 SUBSCRIPTIONS
1. To record collection of 900 subscriptions of $30 each in August.

Aug. Cash 27,000 Subscriptions

Received in
Advance 27,000
(900  30)
2. To record subscriptions earned during August and recorded on August 31.

8/31 Subscriptions Subscriptions

Received in Revenue 7,500
Advance (7,500)
(40,500 + 27,000 – 60,000)
3. Net income for the month would be understated by $7,500 if the accountant forgot
to make the adjustment to recognize revenue earned.
LO 5 EXERCISE 4-9 CUSTOMER DEPOSITS
1. To record on April 1 receipt of customer deposit for three months of legal service.

4/1 Cash 9,000 Customer

Deposits 9,000
2. To record on April 30 one month of legal fees earned.

4/30 Customer Legal Fees

Deposits (3,000) Earned 3,000
(9,000/3)
3. If the April 30 adjustment is not recorded, net income will be understated by $3,000.
LO 5 EXERCISE 4-10 WAGES PAYABLE
1. Weekly payroll: $10 per hour  7 hours per day  5 days  50 employees =
$17,500
2. To record payment of weekly payroll on October 27.

10/27 Cash (17,500) Wages Expense (17,500)
3. To record accrual for two days’ wages on October 31.

10/31 Wages Payable 7,000 Wages Expense (7,000)

(17,500/5 days × 2 days)
4. To record payment of weekly payroll on November 3.

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

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

3/1 Cash 100,000 Note Payable 100,000
2. To accrue interest due on note for one month on March 31.

3/31 Interest Payable 1,000 Interest Expense (1,000)

(100,000  .12  30/360)
To accrue interest due on note for one month on April 30.

4/30 Interest Payable 1,000 Interest Expense (1,000)
3. To record payment of note and interest at maturity date on May 30.

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

Interest
Payable (2,000)
LO 5 EXERCISE 4-12 PROPERTY TAXES PAYABLE—

ANNUAL ADJUSTMENTS
1. To accrue 2007 property taxes on December 31.

2007
12/31 Property Taxes Property Tax
Payable 52,500 Expense (52,500)
(50,000  1.05)
EXERCISE 4-12 (Concluded)
2. To record payment of 2007 property taxes on June 1.

2008
6/1 Cash (52,500) Property Taxes
Payable (52,500)
LO 5 EXERCISE 4-13 INTEREST RECEIVABLE
1. To record 10%, 60-day loan to MaxiDriver Inc. on June 1.

6/1 Cash (60,000)

Note
Receivable 60,000
2. To accrue interest due on note for one month on June 30.

6/30 Interest Interest

Receivable 500 Income 500
(60,000  .10  30/360)
3. To record collection of note and interest at maturity date on July 31.

7/31 Cash 61,000 Interest Income 500

Note
Receivable (60,000)
Interest
Receivable (500)
LO 5 EXERCISE 4-14 UNBILLED ACCOUNTS RECEIVABLE
1. Under the revenue recognition principle, revenue should be recorded when

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.

6/30 Accounts Service Fees

Receivable 40,000 Earned 40,000
LO 5 EXERCISE 4-15 THE EFFECT OF IGNORING ADJUSTMENTS

ON NET INCOME
1. O 4. O
2. U 5. O
3. O 6. U
LO 5 EXERCISE 4-16 THE EFFECT OF ADJUSTMENTS ON THE

ACCOUNTING EQUATION
Assets = Liabilities + Stockholders’ Equity

1. D NE D
2. NE I D
3. D NE D
4. NE D I
5. I NE I
6. NE I D
LO 6 EXERCISE 4-17 THE ACCOUNTING CYCLE
Order in the accounting cycle: 4, 7, 1, 5, 3, 6, 2

MULTI-CONCEPT EXERCISES
LO 1,2,3 EXERCISE 4-18 REVENUE RECOGNITION, CASH AND

ACCRUAL BASIS
1. Accrual-basis income statements:
HATHAWAY HEALTH CLUB

INCOME STATEMENTS
FOR THE YEARS ENDED DECEMBER 31
Year 1 Year 2 Year 3

Sales*$ 122,000 $152,000 $ 182,000
Expenses:
Depreciation** $ 33,000 $ 33,000 $ 33,000
Salaries and wages 50,000 50,000 50,000
Advertising 5,000 5,000 5,000
Rent and utilities 36,000 36,000 36,000
Total expenses $124,000 $124,000 $ 124,000
Net income (loss) $ (2,000) $ 28,000 $ 58,000
*Year 1: $366,000/3 = $122,000 with a three-year membership; only one-third of

the total recognized.
Year 2: $122,000 + [(100)($900)/3] (additional three-year memberships sold in

second year, but only one-third recognized as revenue) = $152,000.
Year 3: $122,000 + $30,000 (additional year of revenue recognized on

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 EXERCISE 4-19 DEPRECIATION EXPENSE
1. Depreciation expense for 2007:

Truck [($18,000 – $3,000)/5]  9/12 = $2,250
Computer [($55,000 – $5,000)/10]  6/12 = $2,500
Building [($250,000 – $10,000)/30]  3/12 = $2,000
2. Certainly, it would be less costly in terms of the time spent by the accountant to
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 EXERCISE 4-20 ACCRUAL OF INTEREST ON A LOAN
1. To record two-month, 12% bank loan on July 1.

a. 7/1 Cash 50,000 Notes Payable 50,000
To accrue one-month interest on bank loan on July 31.

b. 7/31 Interest Payable 500 Interest Expense (500)

(50,000  .12  1/12)
To record repayment of principal and interest on bank loan on August 31.

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

Notes Payable (50,000)
2. It would save the time and cost in making a journal entry to skip an adjustment on
July 31 and simply record interest when the loan is repaid on August 31. However,
to do so would violate the matching principle. One of the necessary costs in July
was interest, and it should be matched with the revenues of that period. If interest
were not accrued at the end of July, the expense for that month would be
understated and the expense for August would be overstated.
PROBLEMS
LO 5 PROBLEM 4-1 ADJUSTMENTS
1. Adjustments on March 31, 2007:
To accrue interest.

a. 3/31 Interest Payable 100 Interest Expense (100)

(15,000  .08  30/360)
To record supplies used.

b. 3/31 Office Supplies Supplies Expense (660)

on Hand (660)
(1,280 + 750 – 1,370)
To record depreciation.

c. 3/31 Accumulated Depreciation

Depreciation— Expense (800)
Office
Equipment (800)
(62,600 – 5,000)  1/72
To accrue wages.

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

(950  6)
To recognize rent earned.

e. 3/31 Rent Collected Rent Revenue 2,500

in Advance (2,500)
PROBLEM 4-1 (Concluded)
To record customer deposits earned.

f. 3/31 Customer Service Revenue 1,200

Deposits (1,200)
(4,800/4)
To record estimated income taxes.

g. 3/31 Income Tax Income Tax

2. Income before adjustments $ 23,000

Rent revenue + 2,500
Service revenue + 1,200
Interest expense (100)
Supplies expense (660)
Depreciation expense (800)
Wages expense (5,700)
Income tax expense (3,900)
Adjusted net income $ 15,540
LO 5 PROBLEM 4-2 ANNUAL ADJUSTMENTS
1. Adjustments on December 31, 2007:
To record annual depreciation expense.

a. 12/31 Accumulated Depreciation

(15,000 – 250)/5 years
To record supplies used during the year.

b. 12/31 Supplies Supplies

on Hand (19,350) Expense (19,350)
(3,600 + 17,600 – 1,850)
To record customer deposits earned between August and December.

c. 12/31 Customer Fees Earned 20,000

Deposits (20,000)
(24,000/6 months) × 5 months
To record rent expense for November through December.

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

(2,700 × 2)
To accrue interest payable on note.

e. 12/31 Interest Payable 3,000 Interest Expense (3,000)

(200,000 × .09 × 60/360)
To accrue wages payable at year-end.

f. 12/31 Wages Payable 500 Wage Expense (500)
2. Net increase (decrease) in net income from adjustments:

a. Depreciation expense $ (2,950)
b. Supplies expense (19,350)
c. Fees earned 20,000
d. Rent expense (5,400)
e. Interest expense (3,000)
f. Wage expense (500)
Overstatement of 2007 net income $ (11,200)
LO 5 PROBLEM 4-3 RECURRING TRANSACTIONS AND

ADJUSTMENTS
a. 1, 12, 13 i. 8, 1
b. 5, 1 j. 17, 9
c. 7, 1, 11 k. 15, 4
d. 3, 1 l. 16, 3
e. 4, 8 m. 11, 19, 1
f. 1, 14 n. 18, 6
g. 1, 2 o. 20, 10
h. 2, 14
LO 5 PROBLEM 4-4 USE OF ACCOUNT BALANCES AS A

BASIS FOR ANNUAL ADJUSTMENTS
To recognize expired insurance.

a. 12/31 Prepaid Insurance

Insurance (1,000) Expense (1,000)
(7,200  5/36)
To recognize rent earned.

b. 12/31 Rent Collected in Rent Revenue 3,500

Advance (3,500)
(6,000  7/12)
To recognize interest earned.

c. 12/31 Interest Interest Revenue 1,500

Receivable 1,500
(50,000  .09  4/12)
2. If adjustments were made at the end of each month, the Prepaid Insurance account
would have been reduced by the monthly expense of $200 ($7,200/36) on four
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.
LO 5 PROBLEM 4-5 USE OF ACCOUNT BALANCES AS A BASIS

FOR ADJUSTMENTS
1. Adjustments on April 30, 2007:
To recognize one month’s insurance expense.

a. Prepaid Insurance (50) Insurance Expense (50)
To record supplies used.

b. Office Supplies (70) Office Supplies

(250 – 180) Expense (70)

c. Accumulated Depreciation
Office Equip-
ment (417)
(50,000  1/120)

d. Accumulated Depreciation
Automobile (200)
(12,000  1/60)
To record commissions earned.

e. Unearned Commissions
Commissions (4,500) Earned 4,500
(9,500 – 5,000)
To record revenue earned, not yet collected.

f. Accounts Commissions
Receivable 1,500 Earned 1,500
To record interest on note payable.

g. Interest Payable 20 Interest Expense (20)
To record salaries not yet paid.

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

Insurance expense $ (50)
Office supplies expense (70)
Commissions earned 4,500
Commissions earned 1,500
Salaries expense (2,500)
Net increase in net income $ 2,743
3. The office equipment was purchased on April 1, 2006, and has been depreciated
for one year before depreciation is recorded for the month of April 2007. Thus, if
the equipment has a 10-year life, the balance in Accumulated Depreciation will be
$50,000/10 years, or $5,000.
LO 5 PROBLEM 4-6 RECONSTRUCTION OF ADJUSTMENTS FROM

ACCOUNT BALANCES
1. To record insurance expense on June 30.

6/30 Prepaid Insurance (150) Insurance Expense (150)

(3,600 – 3,450)
2. Cost of policy was $150  36 months = $5,400.
3. To record depreciation expense on June 30.


(Depreciation (80) Expense (80)
(1,360 – 1,280)
4. Estimated useful life in months: $9,600/$80 month = 120 months.
5. To record interest expense on June 30.

6/30 Interest Payable 144 Interest Expense (144)

(2,448 – 2,304)
6. Interest rate: ($144 per month  12 months)/$9,600 = 18%.

The monthly rate is 18%/12 months = 1.5%.
LO 5 PROBLEM 4-7 USE OF ACCOUNT BALANCES AS A

BASIS FOR ADJUSTMENTS
1. Recording adjustments:
To record rent expense.

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

PROBLEM 4-7 (Continued)
To record expense of worn-out videos.

b. Video Inventory (2,460) Video Expense (2,460)
To record depreciation expense on display stands.

Depreciation (140) Expense (140)
To record unpaid wages and salaries.

d. Wages and Wages and

Salaries Salary
To record subscription revenue earned.

e. Customer Subscription
Subscriptions (2,440) Revenue 2,440
To record accrued income taxes.

f. Income Taxes Income Tax

Payable 849 Expense (849)
Explanations:
(a) $7,200/12 months
(b) $25,600 – $23,140
(c) ($8,900 – $500)/60 months

(f) Calculation of taxes due:
Subscription revenue $ 2,440
Rental revenue 9,200
Wage and salary expense ($2,320 + $1,450) (3,770)
Utility expense (1,240)
Advertising expense (600)
Rent expense (600)
Video expense (2,460)
Income before tax $ 2,830
 tax rate 0.30
Income tax expense $ 849
2. On the basis of the information available, Four Star appears to be a profitable

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 $ 1,000,000

Less: Amounts not yet received 150,000
Cash revenue $ 850,000
Accrual revenue: 500,000 components  $2 $ 1,000,000
2. Under the matching principle, Drysdale should match all expenses to revenues
generated. Thus, all expenses should be recognized during the year, except for the
cost of the truck. The cost of $10,000 should be spread over the estimated useful
life of five years.
3. Income statement under the accrual basis:
DRYSDALE COMPANY
INCOME STATEMENT
FOR THE YEAR ENDED XX/XX/XX
Sales revenue $ 1,000,000

Cost of goods sold 602,000*
Gross profit $ 398,000
Operating expenses:
Sales and administrative salaries $ 100,000
Truck depreciation 2,000**
Total operating expenses $ 102,000
Net income $ 296,000
*Rent: $1,000  12 $ 12,000

Raw materials 400,000
Salaries and wages 190,000
Cost of goods sold $ 602,000
**$10,000/5 years
LO 3,4 PROBLEM 4-9 REVENUE AND EXPENSE

RECOGNITION
Income statements for Years 1 and 2:
DARBY DELIVERY SERVICE

INCOME STATEMENTS
Year 1 Year 2
Sales revenue (a) $ 23,000 $ 46,000
Expenses:
Advertising (b) $ 2,000 $ 1,500
Salaries (c) 15,000 24,000
Rent (d) 5,000 5,000
Total expenses $ 22,000 $ 30,500
Net income $ 1,000 $ 15,500
Explanations:
a. Let X = Year 1 sales
Year 1 sales + 2(Year 1 sales) = $69,000
3X = $69,000;
X = $23,000 = Year 1 sales
2X = $46,000 = Year 2 sales
b. Total advertising expense $3,500
Less promotional portion 500
Total weekly expense $3,000 or $1,500/year
Year 1 advertising = $500 + $1,500 = $2,000
Year 2 advertising = $1,500
c. Let X = one employee's annual salary
1st year = X + 0.25X
2nd year = 2X
X + 0.25X + 2X = $39,000
3.25X = $39,000; X = $12,000
1st year = $12,000 + 0.25($12,000) = $15,000
2nd year = 2($12,000) = $24,000
d. Same rent for two years: $10,000/2 = $5,000
LO 5,6 PROBLEM 4-10 MONTHLY TRANSACTIONS,

ADJUSTMENTS, AND FINANCIAL STATEMENTS
1. Effects on the accounting equation:
To record issuance of stock to owners on January 2.

1/2 Cash 60,000 Capital

(3  20,000) Stock 60,000
To record purchase of a Victorian inn on January 2.

1/2 Land 15,000

House 35,000
Cash (50,000)
To record issuance of two-year, 12% promissory note on January 3.

1/3 Cash 30,000 Notes Payable 30,000
To record purchase of furniture for cash on January 4.

1/4 Furniture 15,000

Cash (15,000)
To record purchase of 24-month insurance policy on January 5.

1/5 Prepaid
Insurance 6,000
Cash (6,000)
To record payment for advertising on January 6.

1/6 Cash (450) Advertising

Expense (450)
To record purchase of cleaning supplies on account on January 7.

1/7 Cleaning Accounts Payable 950

Supplies 950
To record payment of wages for first half of month on January 15.

1/15 Cash (4,230) Wages Expense (4,230)
To record guest's prepayment for two-week stay on January 16.

1/16 Cash 980 Rent Received

in Advance 980
To record cash receipts from rentals for January on January 31.

1/31 Cash 8,300 Revenue from

Rental of Rooms 8,300
To record cash receipts from restaurant for January on January 31.

1/31 Cash 6,600 Restaurant

Revenue 6,600
To record payment of dividends for January on January 31.

1/31 Cash (600) Dividends (600)

(3 × 200)
2. List of accounts and account balances:

Assets
Cash $ 29,600
Land 15,000
House 35,000
Furniture 15,000
Prepaid Insurance 6,000
Cleaning Supplies 950
Liabilities
Accounts Payable $ 950
Notes Payable 30,000
Rent Received in Advance 980
Owners’ Equity
Capital Stock $ 60,000
Advertising Expense 450
Wages Expense 4,230
Revenue from Rental of Rooms 8,300
Restaurant Revenue 6,600
Dividends 600
3. Adjustments:
To record depreciation expense on the house.

a. Accumulated Depreciation
House (100)
To record depreciation expense on the furniture.

b. Accumulated Depreciation
Depreciation— Expense—
Furniture (125) Furniture (125)
To record interest on the note.

c. Interest Payable 300 Interest Expense (300)

To record expired insurance.

d. Prepaid Insurance (250) Insurance Expense (250)
To record earned portion of guest’s deposit.

e. Rent Received Revenue from

in Advance (490) Rental of Rooms 490
To record wages earned by employees.

f. Wages Payable 5,120 Wages Expense (5,120)
To record use of cleaning supplies.

g. Cleaning Supplies (720) Supplies Expense (720)
To record utility expense.

h. Utilities Payable 740 Utilities Expense (740)
To record income tax expense.

i. Income Tax Income Tax

Explanations for adjusting entry amounts:

(a) ($35,000 – $5,000)/300 months = $100/month
(b) $15,000/120 months = $125/month
(c) $30,000  12%  1/12 = $300/month
(d) $6,000/24 months = $250/month
(e) $980/2 weeks = $490/week
(f) $5,120 for second half of month
(g) $950 – $230 = $720 used
(h) $740 due at end of month
(i) Calculation of tax expense:
Revenue from rental of rooms $ 8,790
Restaurant revenue 6,600
Depreciation on house (100)
Depreciation on furniture (125)
Insurance expense (250)
Supplies expense (720)
Utilities expense (740)
 Tax rate 0.30
Income tax expense $ 1,007
4. Financial statements:
(a) MOONLIGHT BAY INN

INCOME STATEMENT
FOR THE MONTH ENDED JANUARY 31, 2007
Revenues:
From rental of rooms $ 8,790
From restaurant 6,600
Total revenues $ 15,390
Expenses:
Advertising $ 450
Wages 9,350
Depreciation—house 100
Depreciation—furniture 125
Interest 300
Insurance 250
Supplies 720
Utilities 740
Income taxes 1,007
Total expenses 13,042
Net income $ 2,348
(b) MOONLIGHT BAY INN

STATEMENT OF RETAINED EARNINGS
Beginning balance, January 1, 2007 $ 0

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

(c) MOONLIGHT BAY INN
BALANCE SHEET
JANUARY 31, 2007
Assets
Current assets:
Cash $ 29,600
Cleaning supplies 230
Prepaid insurance 5,750
Total current assets $ 35,580
Property, plant, and equipment:
Land $ 15,000
House $ 35,000
Less: Accumulated
depreciation 100 34,900
Furniture $ 15,000
Less: Accumulated
depreciation 125 14,875
Total property, plant, and
equipment 64,775
Total assets $ 100,355
Liabilities
Current liabilities:
Accounts payable $ 950
Interest payable 300
Wages payable 5,120
Income tax payable 1,007
Rent received in advance 490
Utilities payable 740
Total current liabilities $ 8,607
Long-term debt:
Notes payable 30,000
Total liabilities $ 38,607
Stockholders’ Equity
Capital stock $ 60,000
Retained earnings 1,748
Total stockholders’ equity $ 61,748
Total liabilities and stockholders’
equity $ 100,355
5. The inn has shown the ability to make a profit. The profit margin is
$2,348/$15,390, or approximately 15%. This is an indication that the inn has
been able to generate revenues and control the necessary costs in the process.
The balance sheet shows a very strong current position for the inn. The current
ratio is $35,580/$8,607, or over 4 to 1. The inn has almost enough cash on
hand at the present time to repay the loan. On the basis of the financial
statements alone, it appears that the banker should be comfortable with the
loan made.
ALTE R N ATE P R O B L E M S
LO 5 PROBLEM 4-1A ADJUSTMENTS
1. Adjustments on June 30, 2007:
a. To accrue interest: $10,000  4%  1/12.

6/30 Interest Receivable 33 Interest Revenue 33
b. To record supplies used: $475 + $5,600 – $507.

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

on Hand (5,568)
c. To record depreciation: ($170,000 – $2,000)  1/48.


Depreciation— Expense (3,500)
Machinery (3,500)
d. To record rent expense: $4,650/3.

6/30 Prepaid Rent (1,550) Rent Expense (1,550)
e. To accrue wages: $7,000.

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

PROBLEM 4-1A (Concluded)
f. To record estimated income taxes.

6/30 Income Taxes Income Tax

2. Income before adjustments $ 35,000

Interest revenue 33
Supplies expense (5,568)
Depreciation expense (3,500)
Rent expense (1,550)
Income tax expense (2,900)
Adjusted net income $ 15,515
LO 5 PROBLEM 4-2A ANNUAL ADJUSTMENTS
1. Adjustments:
a. To record annual depreciation expense: ($25,000 – $4,000)/7 years.


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

12/31 Supplies Supplies

on Hand (13,200) Expense (13,200)
c. To record customer deposits earned between July and December: ($8,800/8

months)  6 months.

12/31 Customer Fees Earned 6,600

Deposits (6,600)
d. To record rent expense for September through December: $4,000  4.

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

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

12/31 Wages Payable 830 Wage Expense (830)

a. Depreciation expense $ (3,000)
b. Supplies expense (13,200)
c. Fees earned 6,600
d. Rent expense (16,000)
e. Interest expense (300)
f. Wage expense (830)
Overstatement of 2007 net income $ (26,730)
LO 5 PROBLEM 4-3A RECURRING TRANSACTIONS AND

ADJUSTMENTS
a. 1, 11, 12 i. 2, 13
b. 5, 1 j. 17, 6
c. 2, 1 k. 19, 9
d. 4, 7 l. 14, 4
e. 1, 3 m. 15, 3
f. 1,18
g. 16,1
h. 5, 1,10
LO 5 PROBLEM 4-4A USE OF ACCOUNT BALANCES AS A

BASIS FOR ANNUAL ADJUSTMENTS
a. To record supplies used: $5,790 – $1,520.

12/31 Supplies (4,270) Supplies

Expense (4,270)
b. To recognize revenue earned: $1,800  8/12.

12/31 Unearned Service Revenue 1,200

Revenue (1,200)
c. To record interest on note: $60,000  10%  4/12.

12/31 Interest Interest Expense (2,000)

Payable 2,000
2. If adjustments were made at the end of each month, the Unearned Revenue
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.

1. Adjustments on June 30, 2007:
a. To recognize one month's rent expense.

6/30 Prepaid Rent (600) Rent Expense (600)
b. To record supplies used: $15,210 – $1,290.

6/30 Office Supplies

Supplies (13,920) Expense (13,920)
c. To record depreciation: ($46,120 – $6,120)  1/120.


Equipment (333)
d. To record interest on note payable.

e. To record salaries not yet paid.

6/30 Salaries Payable 620 Salaries Expense (620)


a. $ (600)
b. (13,920)
c. (333)
d. (50)
e. (620)
Net decrease in net income from adjustments $ (15,523)
3. The office equipment was purchased on June 1, 2006, and has been depreciated
for one year before depreciation is recorded for the month of June 2007. Thus, if
the equipment has a 10-year life, the balance in Accumulated Depreciation will be
($46,120 – $6,120/10 years), or $4,000.
LO 5 PROBLEM 4-6A RECONSTRUCTION OF ADJUSTMENTS

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

2. At $1,000 per month, the original six-month payment and balance of Prepaid Rent
on April 1, 2007, was $6,000.
3. To record depreciation expense on June 30: $900 – $800.


4. Estimated useful life in months: $9,600/$100 month = 96 months.
5. To record interest expense on June 30: $864 – $768.

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

1. Adjustments:

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


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

d. Wages and Wages and

Salaries Salary

e. Income Taxes Income Tax

Explanations:
(a) $4,800/12 months = $400/month
(b) ($18,200 – $200)/120 months = $150/month
(c) ($9,400 – $1,300) = $8,100
(e) Calculation of taxes due:

Treatment revenue $ 40,600
Wages and salary expense (23,580)
Utility expense (1,240)
Rent expense (400)
Chemical expense (8,100)
 Tax rate 0.30
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 PROBLEM 4-8A CASH AND ACCRUAL INCOME

2,3,4 STATEMENTS FOR A MANUFACTURER
1. Cash revenue: 50,000 sandwiches  $2 $ 100,000

Less: Amounts not yet received 25,000
Cash revenue $ 75,000
Accrual revenue: 50,000 sandwiches  $2 $ 100,000
2. Accountants recognize revenue under an accrual accounting system when it is

earned. In the catering business, revenue is earned as the sandwiches are
delivered to the vendors. Marie’s might consider using the cash method to account
for sales of sandwiches if there is a significant amount of uncertainty about the
collectibility of accounts receivable.
3. Income statement under the accrual basis:
MARIE’S CATERING
INCOME STATEMENT
FOR THE YEAR ENDED XX/XX/XX
Sales revenue $100,000

Cost of goods sold 69,600*
Gross profit $ 30,400
Operating expenses:
Office salaries $ 12,000
Equipment depreciation 1,000**
Truck depreciation 2,800***
Total operating expenses $ 15,800
Net income $ 14,600
*Rent: $800  12 $ 9,600

Raw materials 25,000
Salaries and wages 35,000
Cost of goods sold $69,600
**$10,000/10 years
***$14,000/5 years
LO 3,4 PROBLEM 4-9A REVENUE AND EXPENSE

RECOGNITION
Income statements for the first two years:
SUE’S AUDIO BOOK RENTALS

INCOME STATEMENTS
Year 1 Year 2
Sales revenue (a) $ 21,000 $ 63,000
Expenses:
Advertising (b) $ 6,000 $ 4,500
Salaries 0 12,000
Depreciation (c) 2,500 2,500
Rent (d) 9,000 9,000
Total expenses $ 17,500 $ 28,000
Net income $ 3,500 $ 35,000
Explanations:
a. Let X = Year 1 sales:
Year 1 sales + 3(Year 1 sales) = $84,000
4X = $84,000
X = $21,000 = Year 1 sales
3X = $63,000 = Year 2 sales
b. Total advertising expense $ 10,500
Less promotional portion 1,500
Total ad expense $ 9,000 or $4,500/year
Year 1 advertising = $4,500 + $1,500 = $6,000
Year 2 advertising = $4,500
c. Depreciation per year = $5,000/2 = $2,500/year
d. Rent per year = $18,000/2 = $9,000/year

LO 5,6 PROBLEM 4-10A ADJUSTMENTS AND

FINANCIAL STATEMENTS
1. Adjustments:

a. Prepaid Insurance Expense (750)

Insurance (750)

Warehouse (150) Warehouse (150)

Truck Fleet (3,125) Truck Fleet (3,125)

d. Interest Payable 375 Interest Expense (375)

e. Customer Freight Revenue 4,500

Deposits (4,500)

f. Wages and Wages and

Salaries Salary

g. Income Taxes Income Tax

PROBLEM 4-10A (Continued)

Explanations for adjusting entry amounts:
(a) $18,000/24 months = $750/month
(b) ($40,000 – $4,000)/240 months = $150/month
(c) ($240,000 – $15,000)/72 months = $3,125/month
(d) ($50,000  9%)  1/12 = $375
(g) Calculation of income tax expense:
Freight revenue $ 170,170
Gas and oil expense (57,330)
Maintenance expense (26,400)
Wage and salary expense (51,250)
Insurance expense (750)
Depreciation on warehouse (150)
Depreciation on truck fleet (3,125)
 Tax rate 0.30
2. Financial statements:
(a) TENFOUR TRUCKING COMPANY

INCOME STATEMENT
Freight revenue $ 170,170
Expenses:
Gas and oil $ 57,330
Maintenance 26,400
Wages and salaries 51,250
Insurance 750
Depreciation—warehouse 150
Depreciation—truck fleet 3,125
Interest 375
Income taxes 9,237 148,617
Net income $ 21,553
(b) TENFOUR TRUCKING COMPANY

STATEMENT OF RETAINED EARNINGS
Beginning balance, January 1, 2007 $ 40,470
$ 62,023
Deduct: Cash dividends 20,000
Ending balance, January 31, 2007 $ 42,023
PROBLEM 4-10A (Continued)

(c) TENFOUR TRUCKING COMPANY
BALANCE SHEET
JANUARY 31, 2007
Assets
Current assets:
Cash $ 27,340
Accounts receivable 41,500
Prepaid insurance 17,250
Land $ 20,000
Warehouse $ 40,000
Less: Accumulated
depreciation 21,750 18,250
Truck fleet $ 240,000
Less: Accumulated
depreciation 115,625 124,375
Total property, plant, and
equipment 162,625
Liabilities
Accounts payable $ 32,880
Notes payable 50,000
Interest payable 4,875
Customer deposits 1,500
Wages and salaries payable 8,200
Income tax payable 9,237
Total stockholders’ equity 142,023
Total liabilities and stockholders’
equity $ 248,715
3. Current ratio = Current assets/Current liabilities
$86,090/$106,692 = 0.81 to 1
Tenfour may have difficulties in meeting all of its current obligations. Especially
noteworthy is the significantly higher amount of accounts receivable at year-end
compared with cash (cash and accounts receivable constitute 32% and 48% of the
current assets, respectively). It is also worth noting that the other 20% of the
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
READING AND INTERPRETING FINANCIAL STATEMENTS
LO 1,2,3 DECISION CASE 4-1 COMPARING TWO COMPANIES IN THE SAME INDUSTRY:
FINISH LINE AND FOOT LOCKER
1. According to Note 1 in its annual report, Finish Line recognizes revenue when the
customer receives the merchandise. Foot Locker indicates in its Note 1 that revenue
from stores is recognized when the product is delivered to customers. The
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
company’s 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 Locker’s 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.
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 DECISION CASE 4-2 READING AND INTERPRETING SEARS,

ROEBUCK’S NOTES—REVENUE RECOGNITION
1. Under the accrual basis, revenue should be recognized when it is earned rather
than when cash is received. Over the life of a service contract, the retailer will incur
costs to repair damaged merchandise. The retailer earns revenue over the life of
the service contract.
2. Revenue to be recognized each year:
Year 1 Year 2 Year 3 Total

Sales revenue $2,320* $ 0 $ 0 $ 2,320
Service contract revenue 60** 60 60 180
Total revenue $2,380 $ 60 $ 60 $ 2,500
*$2,500 – $180
**$180/3 years
When a retailer sells a service contract, it receives cash and at the same time
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 contracts—a 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.
MAKING FINANCIAL DECISIONS
LO 2,3,4 DECISION CASE 4-3 THE USE OF NET INCOME

AND CASH FLOW TO EVALUATE A COMPANY
1. DUKE INC.
STATEMENT OF CASH FLOWS
FOR THE YEAR ENDED DECEMBER 31, 2007
Operating Activities:
Cash received from services
provided to clients $ 1,020,000*
Cash paid for:
Salaries and wages $ 440,000**
Supplies 100,000
Utilities 30,000
Rent 180,000*** 750,000
Net increase in cash $ 270,000
*$1,250,000 – $230,000
**$480,000 – $40,000
***$10,000  18 months
Note to Instructor: You may want to point out to students that the net increase in cash
is also the net cash provided by operating activities for the year. That is, there are no
investing or financing activities because the acquisition of the computer system by the
signing of a promissory note did not result in any net change in cash, if it is 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.
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.
ETHICAL DECISION MAKING
LO 2,3,4,5 DECISION CASE 4-5 REVENUE RECOGNITION AND

THE MATCHING PRINCIPLE
1. If sales are recorded but the commissions associated with these sales are not
recorded during the month of June, net income will be larger by the understatement
of commissions expense. The failure to record advertising expense for the month of
June will also result in an understatement of expense and an overstatement or
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.
DECISION CASE 4-5 (Concluded)
2. The first suggestion, to delay recording the 4% commission expense until July, is a
clear violation of the matching principle. Regardless of when the sales staff is paid
commissions, it is wrong to record the revenues in June but not record the expense
associated with earning that revenue—i.e., commissions—until July. Likewise,
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).
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 $ 10,500

Supplies expense (15,500)
Depreciation expense (5,000)
Revised net income (loss) $ (10,000)
The company was able to generate significant revenues from its services during the
first year. Given this level of revenues, however, it was not able to control its costs,
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 Locker’s report, the largest item at
the end of 2004 was “Other operating costs” and the amount was $55,000,000. At the
end of 2005, the largest item was “Pension and postretirement benefits” of
$72,000,000. The account “Accrued and other liabilities” appears as a current liability
on the balance sheet. The total amounts for accrued liabilities in the note are
$285,000,000 and $305,000,000 at the end of 2004 and 2005, respectively. These
same amounts appear on the balance sheets at the end of the two years.
SOLUTION TO INTEGRATIVE PROBLEM
Part 1
1. Effects on the accounting equation are as follows:

a. Salary and Salary and

Wages Payable 4,000 Wages Expense (4,000)

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

Automobiles (30,000) Automobiles (30,000)

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

e. Extended Extended Warranty

Warranty (3,000) Expense (3,000)

f. Billings Receivable, Medical Services

Net 16,000 Revenue 16,000

g. Interest Payable 3,000 Interest

Expense 3,000
INTEGRATIVE PROBLEM (Continued)
2. MOUNTAIN HOME HEALTH INC.

INCOME STATEMENT
Revenues:
Medical services revenue $ 566,000
Expenses:
Salary and wages expense $292,000
Supplies expense 64,347
Gasoline expense 137,500
Utilities expense 12,000
Interest expense 3,000
Depreciation expense—automobiles 30,000
Depreciation expense—building 10,000
Extended warranty contract expense 3,000
551,847
Net income $ 14,153
MOUNTAIN HOME HEALTH INC.

RETAINED EARNINGS STATEMENT
Beginning balance $ 99,900

Deduct: Dividends (10,000)
Ending balance $ 104,053
INTEGRATIVE PROBLEM (Continued)
3. MOUNTAIN HOME HEALTH INC.

BALANCE SHEET
AS OF DECEMBER 31, 2006
Assets
Current assets:
Cash $ 77,400
Billings receivable, net 167,000
Medical supplies 8,653
Building $ 200,000
Less: Accumulated depreciation (60,000) 140,000
Liabilities and Stockholders’ Equity
Accounts payable $ 22,000
Interest payable 3,000
Salary and wages payable 4,000
Dividend payable 10,000
Long-term liabilities:
Mortgage payable 100,000
Additional paid-in capital 50,000
Total stockholders’ equity 254,053
Total liabilities and stockholders’ equity $ 393,053
4. a. Working capital: $253,053 – $39,000 = $214,053

b. Current ratio: $253,053/$39,000 = 6.5 to 1
5. By their nature, all adjustments cause a difference between the amount of income
recognized on an accrual basis and that recognized on a cash basis. The
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.
INTEGRATIVE PROBLEM (Concluded)
6. Supply of cash needed:

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

Chapter-4 Income Measurement and Accrual Accounting

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Chapter-4 Income Measurement and Accrual Accounting

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CHAPTER 4

Income Measurement and

1. Explain the significance of recognition and measurement 18* 20 Diff

3. Describe the revenue recognition principle and explain its 1 10 Easy

4. Describe the matching principle and the various methods 2 10 Mod

5. Identify the four major types of adjustments and determine 3 10 Easy

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

1. Explain the significance of recognition and measurement

2. Explain the differences between the cash and accrual 8* 25 Mod

3. Describe the revenue recognition principle and explain its

4. Describe the matching principle and the various methods 8* 25 Mod

5. Identify the four major types of adjustments and determine 1 20 Mod

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

1. Explain the significance of recognition and measurement

2. Explain the differences between the cash and accrual 1* 30 Mod

3. Describe the revenue recognition principle and explain its 1* 30 Mod

4. Describe the matching principle and the various methods

5. Identify the four major types of adjustments and determine 5* 60 Diff

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

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

8. Depreciation is the process of allocating the cost of a tangible long-term asset to

LO 3 EXERCISE 4-1 REVENUE RECOGNITION

Cash collected at toll booth $ 3,000,000

LO 4 EXERCISE 4-2 THE MATCHING PRINCIPLE

LO 5 EXERCISE 4-3 ACCRUALS AND DEFERRALS

LO 5 EXERCISE 4-4 OFFICE SUPPLIES

To record office supplies used.

BALANCE SHEET INCOME STATEMENT

5/31 Office Supplies Office Supplies

LO 5 EXERCISE 4-5 PREPAID RENT—QUARTERLY

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

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

BALANCE SHEET INCOME STATEMENT

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

BALANCE SHEET INCOME STATEMENT

9/30 Prepaid Rent Expense (2,000)

LO 5 EXERCISE 4-6 DEPRECIATION

1. To record purchase of combine on July 1.

BALANCE SHEET INCOME STATEMENT

7/1 Equipment 100,000

2. Purchase price $ 100,000

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

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

BALANCE SHEET INCOME STATEMENT

7/31 Accumulated Depreciation

LO 5 EXERCISE 4-7 PREPAID INSURANCE—ANNUAL

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

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

BALANCE SHEET INCOME STATEMENT

EXERCISE 4-7 (Concluded)

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

BALANCE SHEET INCOME STATEMENT

12/31 Prepaid Insurance

4. Net income will be overstated by $27,000 if the accountant forgets to record an

LO 5 EXERCISE 4-8 SUBSCRIPTIONS

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

BALANCE SHEET INCOME STATEMENT

Aug. Cash 27,000 Subscriptions

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

BALANCE SHEET INCOME STATEMENT

8/31 Subscriptions Subscriptions

LO 5 EXERCISE 4-9 CUSTOMER DEPOSITS

BALANCE SHEET INCOME STATEMENT