4-1 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. 19* 15 Mod 2. Explain the differences between the cash and accrual bases 18* 20 Diff of accounting. 19* 15 Mod 3. Describe the revenue recognition principle, and explain its 1 10 Easy application in various situations. 18* 20 Diff 19* 15 Mod 4. Describe the matching principle and the various methods for 2 10 Mod recognizing expenses. 20* 15 Mod 21* 15 Mod 5. Identify the four major types of adjusting entries and prepare 3 10 Easy them for a variety of situations. 4 10 Easy 5 20 Easy
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4-1
CHAPTER 4
Income Measurement and Accrual Accounting
OVERVIEW OF EXERCISES, PROBLEMS, AND CASESEstimated
Time inLearning Objective Exercises Minutes Level
1. Explain the significance of recognition and measurement 18* 20 Diffin the preparation and use of financial statements. 19* 15 Mod
2. Explain the differences between the cash and accrual bases 18* 20 Diffof accounting. 19* 15 Mod
3. Describe the revenue recognition principle, and explain its 1 10Easy
application in various situations. 18* 20 Diff19* 15 Mod
4. Describe the matching principle and the various methods for 2 10 Modrecognizing expenses. 20* 15 Mod
21* 15 Mod
5. Identify the four major types of adjusting entries and prepare 3 10Easy
them for a variety of situations. 4 10Easy
5 20Easy
6 20Easy
7 15Easy
8 15Easy
9 15Easy
10 15 Mod11 15
Easy12 15
Easy13 15
Easy
4-2 FINANCIAL ACCOUNTING SOLUTIONS MANUAL
14 15Easy
15 10 Mod16 15 Mod20* 15 Mod21* 15 Mod
*Exercise, problem, or case covers two or more learning objectivesLevel = Difficulty levels: Easy; Moderate (Mod); Difficult (Diff)
Continued
CHAPTER 4 INCOME MEASUREMENT AND ACCRUAL ACCOUNTING 4-3
6. Explain the steps in the accounting cycle and the significance 17 5Easy
of each step.
4-4 FINANCIAL ACCOUNTING SOLUTIONS MANUAL
Problems Estimatedand 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 bases 9* 25 Modof accounting.
3. Describe the revenue recognition principle, and explain its 1 25 Modapplication in various situations. 9* 25 Mod
10* 25 Diff11* 30 Diff
4. Describe the matching principle and the various methods for 9** 25 Modrecognizing expenses. 10* 25 Diff
11 30 Diff
5. Identify the four major types of adjusting entries and prepare 2 20 Modthem for a variety of situations. 3 20 Mod
4 20 Mod5 15 Mod6 20 Mod7 25 Mod8 15 Mod
12* 60 Mod
6. Explain the steps in the accounting cycle and the significance 12* 90 Modof each step.
*Exercise, problem, or case covers two or more learning objectives# Original problem only**Alternate problem onlyLevel = Difficulty levels: Easy; Moderate (Mod); Difficult (Diff)
CHAPTER 4 INCOME MEASUREMENT AND ACCRUAL ACCOUNTING 4-5
EstimatedTime in
Learning Objective Cases 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 bases 5* 30 Modof accounting. 7* 60 Diff
3. Describe the revenue recognition principle, and explain its 1* 30 Modapplication in various situations. 2 30 Mod
3 20 Mod4 25 Mod5* 30 Mod7* 60 Diff
4. Describe the matching principle and the various methods for 1* 30 Modrecognizing expenses. 5* 30 Mod
6 25 Mod7* 60 Diff8 45 Mod
5. Identify the four major types of adjusting entries and prepare 1* 30 Modthem for a variety of situations. 7* 60 Diff
6. Explain the steps in the accounting cycle and the significance of each step.
*Exercise, problem, or case covers two or more learning objectivesLevel = Difficulty levels: Easy; Moderate (Mod); Difficult (Diff)
4-6 FINANCIAL ACCOUNTING SOLUTIONS MANUAL
Q U E S T I O N S
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.
CHAPTER 4 INCOME MEASUREMENT AND ACCRUAL ACCOUNTING 4-7
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. The percentage of completion method is used by contractors to spread the recognition of revenue over the life of the project. Revenue is earned over the life of a project rather than at any one point in time. It makes sense for the contractor to recognize revenue as work progresses, rather than to wait and recognize all of the revenue from the project in the year in which the project is completed. It would in fact be a distortion to report all of the revenue in the year of completion.
8. According to professional accounting standards, an initial franchise fee should be recognized as revenue only when the franchiser has made “substantial performance” of its obligations and collection of the fee is reasonably assured. Illinois will recognize the $50,000 fee as revenue when it has assisted the franchisee in selecting a site and has helped to train the personnel.
9. A magazine publisher recognizes revenue at the time the magazines are delivered to the customers. This is the point at which the publisher has earned revenue.
10. The revenue recognition principle calls for the recognition when revenues are either realized or realizable. Revenues are realizable when assets received or held are readily convertible to known amounts of cash or claims to cash. For example, the significant event in the revenue recognition process for a gold mining company is the production of the commodity. Because each ounce of gold is interchangeable and the market can absorb all of the gold the company sells without there being an effect on the price, the actual sale of the gold is secondary to its production. Thus, it is considered acceptable for the company to recognize revenue when the gold is mined rather than when it is sold.
11. 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.
4-8 FINANCIAL ACCOUNTING SOLUTIONS MANUAL
12. 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.
13. 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.
14. 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.
15. 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.
CHAPTER 4 INCOME MEASUREMENT AND ACCRUAL ACCOUNTING 4-9
E X E R C I S E S
LO 3 EXERCISE 4-1 REVENUE RECOGNITION
Cash collected at toll booth $ 3,000,000Passes 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. If the accountant forgot to record an adjustment on December 31, net income for the year would be overstated by $6,000 ($2,000 per month X 3 months).
CHAPTER 4 INCOME MEASUREMENT AND ACCRUAL ACCOUNTING 4-11
7/31 Cash 61,000 Interest Income 500Note Receivable (60,000)Interest Receivable (500)
LO 5 EXERCISE 4-14 UNBILLED ACCOUNTS RECEIVABLE
1. Under the revenue recognition principle, revenue should be recorded when services are performed, because this is the point at which revenue is earned.
2. To record on June 30 unbilled service fees earned during June.
6/30 Accounts Service Fees Receivable 40,000 Earned 40,000
4-16 FINANCIAL ACCOUNTING SOLUTIONS MANUAL
LO 5 EXERCISE 4-15 THE EFFECT OF IGNORING ADJUSTMENTS ON NET INCOME
1. O 4. O2. U 5. O3. O 6. U
LO 5 EXERCISE 4-16 THE EFFECT OF ADJUSTMENTS ON THE ACCOUNTING EQUATION
Assets = Liabilities + Owners' Equity1. D NE D2. NE I D3. D NE D4. NE D I5. I NE I6. NE I D
LO 6 EXERCISE 4-17 THE ACCOUNTING CYCLE
Order in the accounting cycle: 4, 7, 1, 5, 3, 6, 2
MULTI-CONCEPT EXERCISES
LO 1,2,3 EXERCISE 4-18 REVENUE RECOGNITION, CASH AND ACCRUAL BASIS
1. Accrual basis income statements:
HATHAWAY HEALTH CLUBINCOME STATEMENTS
FOR THE YEARS ENDED DECEMBER 31
Year 1 Year 2 Year 3Sales*$ 122,000 $152,000 $182,000 Expenses:
Depreciation** $ 33,000 $ 33,000 $ 33,000Salaries and wages 50,000 50,000 50,000Advertising 5,000 5,000 5,000Rent 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.
CHAPTER 4 INCOME MEASUREMENT AND ACCRUAL ACCOUNTING 4-17
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 1,2,3 EXERCISE 4-19 THE EFFECT OF THE PERCENTAGE-OF-COMPLETION METHOD ON FINANCIAL STATEMENTS
1.Income Recognized Under
Year Percentage-of-Completion Basis Cash Basis1 (1,200,000/2,400,000*) 2,000,000 –
2. Under the percentage-of-completion method, revenue is recognized as it is earned. As work progresses, the amount of revenue and income to recognize is based on the extent of completion. A common method used to estimate the percent of completion is to compare the costs incurred to date to the total estimated costs for the project.
LO 4,5 EXERCISE 4-20 DEPRECIATION EXPENSE
4-18 FINANCIAL ACCOUNTING SOLUTIONS MANUAL
1. Depreciation expense for 2004:Truck [($18,000 – $3,000)/5] X 9/12 = $2,250Computer [($55,000 – $5,000)/10] X 6/12 = $2,500Building [($250,000 – $10,000)/30] X 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 4-21 ACCRUAL OF INTEREST ON A LOAN
2. It would save the time and cost in making a journal entry to skip an adjusting entry 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.
P R O B L E M S
CHAPTER 4 INCOME MEASUREMENT AND ACCRUAL ACCOUNTING 4-19
LO 3 PROBLEM 4-1 THE REVENUE RECOGNITION PRINCIPLE
a. The 6% commission on $150,000, or $9,000, should be recognized on May 1. This is the date on which a sale takes place. It is the date on which the realtor's client accepts the offer to sell the house.
b. Assuming that Chicken King is reasonably assured of collecting the entire fee, it should recognize $10,000 of revenue on March 13. A franchiser must have made "substantial performance" under the agreement to recognize revenue. On this date, Chicken King has provided the service it promised: assistance in selecting a site.
c. The franchiser should recognize revenue of $60,000 X 2%, or $1,200, on June 30. Under the accrual accounting concept, it has earned the franchise fee on this date, regardless of when the franchisee either reports the amount of sales or remits the fee to Chicken King.
Note: Because Chicken King does not receive the report until July 3, it will either need to estimate on June 30 the amount to be received or wait until July 3 to actually make the adjusting entry to accrue revenue. However, the adjusting entry should be dated June 30 and its effect shown in any financial statements prepared as of this date.
d. Goldstar should accrue revenue of $300 X 50 ounces, or $15,000, throughout August as the gold is mined. Under the production method, revenue is recognized at the time of production rather than at the point of sale. The method is appropriate for precious commodities such as gold. The company will have to make an adjustment to recognize an additional $10 per ounce X 50 ounces, or $500 of revenue, on September 5 when the gold is sold.
e. Whatadeal should recognize $2,500 of revenue ($10,000 X 25%) on December 2 when the down payment is received. The remaining $7,500 is recognized on February 1, when it is received in cash. When there is a high degree of uncertainty about the collectibility of an account, the installment method is acceptable. It is essentially a cash basis of recording.
2. Net increase (decrease) in net income from adjustments:a. Depreciation expense $ (2,950)b. Supplies expense (19,350)c. Fees earned 20,000d. Rent expense (5,400)e. Interest expense (3,000)f. Wage expense (500 )Overstatement of 2004 net income $ (11,200 )
CHAPTER 4 INCOME MEASUREMENT AND ACCRUAL ACCOUNTING 4-23
LO 5 PROBLEM 4-4 RECURRING TRANSACTIONS AND ADJUSTMENTS
a. 1, 12, 13 i. 8, 1b. 5, 1 j. 17, 9c. 7, 1, 11 k. 15, 4d. 3, 1 l. 16, 3e. 4, 8 m. 11, 19, 1f. 1, 14 n. 18, 6g. 1, 2 o. 20, 10h. 2, 14
LO 5 PROBLEM 4-5 USE OF ACCOUNT BALANCES AS A BASIS FOR ANNUAL ADJUSTMENTS
c. 12/31 Interest Interest Revenue 1,500 Receivable 1,500
(50,000 X .09 X 4/12)
4-24 FINANCIAL ACCOUNTING SOLUTIONS MANUAL
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 adjusting entry would be $7,200 – [(4)($200)] = $6,400.
LO 5 PROBLEM 4-6 USE OF ACCOUNT BALANCES AS A BASIS FOR ADJUSTMENTS
h. Salaries Payable 2,500 Salaries Expense (2,500)
2. Net increase (decrease) in net income from adjustments:Insurance expense $ (50)Supplies expense (70)Depreciation expense (417)Depreciation expense (200)Commissions earned 4,500Commissions earned 1,500Interest expense (20)Salaries expense (2,500 )Net increase in net income $ 2,743
3. The office equipment was purchased on April 1, 2003, and has been depreciated for one year before depreciation is recorded for the month of April, 2004. Thus, if the equipment has a 10-year life, the balance in Accumulated Depreciation will be $50,000/10 years, or $5,000.
4-26 FINANCIAL ACCOUNTING SOLUTIONS MANUAL
LO 5 PROBLEM 4-7 RECONSTRUCTION OF ADJUSTMENTS FROM ACCOUNT BALANCES
Video expense (2,460)Depreciation expense (140 )Income before tax $ 2,830X tax rate .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 PROBLEM 4-9 CASH AND ACCRUAL INCOME STATEMENTS FOR A MANUFACTURER
1. Cash revenue: 500,000 components X $2 $ 1,000,000Less: amounts not yet received 150,000 Cash revenue $ 850,000 Accrual revenue: 500,000 components X $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 COMPANYINCOME STATEMENT
FOR THE YEAR ENDED XX/XX/XX
Sales revenue $ 1,000,000Cost of goods sold 602,000 *Gross profit $ 398,000 Operating expenses:Sales and administrative salaries $ 100,000Truck depreciation 2,000 **Total operating expenses $ 102,000 Net income $ 296,000
*Rent: $1,000 X 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 4-10 REVENUE RECOGNITION ON
CHAPTER 4 INCOME MEASUREMENT AND ACCRUAL ACCOUNTING 4-29
INSTALLMENT SALES
John is incorrect in suggesting that Frances should recognize revenue on all of the units constructed, regardless of whether they have been sold. It is probably his experience as a farmer that has led him to suggest the production method of accounting. When there is a ready market price for a commodity, at an established price, this method is sometimes used. It is not appropriate, however, as a basis for recognizing revenue from the sale of condominium units.
Frances should recognize revenue in the current year on the units sold: (40 X $50,000) + (30 X $60,000) = $3,800,000. In subsequent years she would make similar calculations, based on the number sold in any particular year. Sometimes revenue from the sale of realty, such as the condos, is recognized on the cash basis because there is considerable uncertainty about collectibility. This is an exception, and the cash basis should be used only if circumstances warrant its use.
The necessary costs to build the condos should be matched with revenues. Costs such as building materials and labor can be directly matched with the revenues generated from the sale of the units and thus should be recognized in the same periods when the revenues are recognized.
LO 3,4 PROBLEM 4-11 REVENUE AND EXPENSE RECOGNITION
1. Income statements for the first two years:
DARBY DELIVERY SERVICEINCOME STATEMENTS
Year 1 Year 2Sales revenue (a) $ 23,000 $ 46,000 Expenses:
(h) $740 due at end of month(i) Calculation of tax expense:
Revenue from rental of rooms $ 8,790Restaurant revenue 6,600Wages expense (9,350)Advertising expense (450)Depreciation on house (100)Depreciation on furniture (125)Interest expense (300)
CHAPTER 4 INCOME MEASUREMENT AND ACCRUAL ACCOUNTING 4-35
Insurance expense (250)Supplies expense (720)Utilities expense (740 )Income before tax $ 3,355X tax rate .30 Income tax expense $ 1,007
4. Financial statements:
(a) MOONLIGHT BAY INNINCOME STATEMENT
FOR THE MONTH ENDED JANUARY 31, 2004
Revenues:From rental of rooms $ 8,790From restaurant 6,600 Total revenues $15,390
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.
CHAPTER 4 INCOME MEASUREMENT AND ACCRUAL ACCOUNTING 4-37
A L T E R N A T E P R O B L E M S
LO 3 PROBLEM 4-1A THE REVENUE RECOGNITION PRINCIPLE
a. Revenue should be recognized as the painting and decorating is completed over the next six months. Revenue is recognized as it is earned.
b. The initial franchise fee of $2,500 for each franchise should be recognized as revenue when the training and accounting systems have been completed. The franchiser is required to render substantial performance of its responsibilities before it recognizes revenue. The ongoing fee of 5% of the franchisees’ revenues should be recognized as the franchisees report revenue. It is over this same period that the franchiser earns revenue.
c. The contractor in this situation should probably use the percentage-of-completion method. It earns revenue as the project is completed regardless of when it receives cash from the county. Dan Diver will eventually report revenue of $500,000 + (20)($75,000), or $2,000,000, but it should be spread over the next 20 months as work progresses.
d. Cropper should use the production method of accounting and recognize the expected sales value of the wheat of $450,000 as revenue when it is harvested. This method is appropriate when products such as commodities can be sold at a quoted price in an active market that can absorb the quantity being sold without significantly affecting the price.
e. Revenue for the store spaces should be recognized when the spaces are sold. For Example, because four spaces were sold during May, $25,000 x 4, or $100,000, should be recognized as revenue.
2. Net increase (decrease) in net income from adjustments:a. Depreciation expense $ (3,000)b. Supplies expense (13,200)c. Fees earned 6,600d. Rent expense (16,000)e. Interest expense (300)f. Wage expense (830 )Overstatement of 2004 net income $ (26,730 )
LO 5 PROBLEM 4-4A RECURRING TRANSACTIONS AND ADJUSTMENTS
a. 1, 11, 12 i. 2, 13b. 5, 1 j. 17, 6c. 2, 1 k. 19, 9d. 4, 7 l. 14, 4e. 1, 3 m. 15, 3f. 1,18g. 16,1h. 5, 1,10
CHAPTER 4 INCOME MEASUREMENT AND ACCRUAL ACCOUNTING 4-41
LO 5 PROBLEM 4-5A USE OF ACCOUNT BALANCES AS A BASIS FOR ANNUAL ADJUSTMENTS
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.
2. Net increase (decrease) in net income from adjustments: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, 2003, and has been depreciated for one year before depreciation is recorded for the month of June 2004. 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 4-7A RECONSTRUCTION OF ADJUSTMENTS FROM ACCOUNT BALANCES
1. To record rent expense on June 30: $4,000 – $3,000.
e. Income Taxes Income Tax Payable 1,881 Expense (1,881)
Explanations:(a) $4,800/12 months = $400/month
(b) ($18,200 – $200)/120 months = $150/month
(c) ($9,400 – $1,300) = $8,100
CHAPTER 4 INCOME MEASUREMENT AND ACCRUAL ACCOUNTING 4-45
(e) Calculation of taxes due:Treatment revenue $ 40,600Wages and salary expense (23,580)Utility expense (1,240)Advertising expense (860)Rent expense (400)Depreciation expense (150)Chemical expense (8,100 )Income before tax $ 6,270X tax rate .30 Income tax expense $ 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%.
ALTERNATE MULTI-CONCEPT PROBLEMS
LO 2,3,4
PROBLEM 4-9A CASH AND ACCRUAL INCOME STATEMENTS FOR A MANUFACTURER
1. Cash revenue: 50,000 sandwiches X $2 $ 100,000Less: amounts not yet received 25,000 Cash revenue $ 75,000 Accrual revenue: 50,000 sandwiches X $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.
4-46 FINANCIAL ACCOUNTING SOLUTIONS MANUAL
3. Income statement under the accrual basis:
MARIE'S CATERING SERVICEINCOME STATEMENT
FOR THE YEAR ENDED XX/XX/XX
Sales revenue $ 100,000Cost of goods sold 69,600 *
Total operating expenses $ 15,800 Net income $ 14,600
* Rent: $800 X 12 $ 9,600Raw materials 25,000Salaries and wages 35,000 Cost of goods sold $ 69,600
** $10,000/10 years*** $14,000/5 years
LO 3,4 PROBLEM 4-10A REVENUE RECOGNITION ON THE PERCENTAGE-OF-COMPLETION AND PRODUCTION METHODS
Cash flow results from the inflow and outflow of cash to a business. It is not the inflow of cash to a business, however, that gives rise to the recognition of revenue. Revenue is recognized as it is earned. Judy should use the production method and recognize revenue before cash is received, because there is a ready market and an established price for the diamonds. On the other hand, Marty should use the percentage-of-completion method and recognize revenue as work progresses on the runways and hangars.
The following schedule compares the amount of revenue each will recognize over the next three years:
Judy Marty2004 $ 1,500,000 $1,500,000 X ($400,000/$1,000,000*) = $ 600,0002005 0 $1,500,000 X ($500,000/$1,000,000) = 750,0002006 0 $1,500,000 X ($100,000/$1,000,000) = 150,000 Total $ 1,500,000 $ 1,500,000
*Estimated total costs: $400,000 + $500,000 + $100,000.
CHAPTER 4 INCOME MEASUREMENT AND ACCRUAL ACCOUNTING 4-47
LO 3,4 PROBLEM 4-11A REVENUE AND EXPENSE RECOGNITION
Income statements for the first two years:
SUE'S AUDIO BOOK RENTALSINCOME STATEMENTS
Year 1 Year 2Sales revenue (a) $ 21,000 $ 63,000 Expenses:
Total stockholders' equity 142,023 Total liabilities and stockholders'
equity $ 248,715
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3. Current ratio = Current assets/Current liabilities
$86,090/$106,692 = .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.
D E C I S I O N C A S E S
READING AND INTERPRETING FINANCIAL STATEMENTS
LO 3, 4, 5
DECISION CASE 4-1 COMPARING TWO COMPANIES IN THE SAME INDUSTRY: WINNEBAGO INDUSTRIES AND MONACO COACH CORPORATION
1. Winnebago Industries reports two current receivables. One account is titled “Receivables, less allowance for doubtful accounts” and the other is titled “Dealer financing receivables, less allowance for doubtful accounts.” Monaco Coach reports one account titled “Trade receivables, net.”
2. Winnebago Industries’ Prepaid expenses account totals $4,314,000 at the end of 2002, while Monaco Coach’s same account totals $3,612,000. When the benefits from this asset expire it is most likely that Winnebago increases“Selling” and/or “General and administrative.” Monaco Coach most likely increases the account “Selling, general and administrative.”
3. Rather than show a separate accumulated depreciation account on its balance sheet, Monaco Coach uses the account “Property, plant and equipment, net.” That is, the accumulated depreciation has been deducted from the asset to arrive at a net amount. Monaco Coach chooses to report the amount of accumulated depreciation in one of the notes to the financial statements. Companies have flexibility as to whether they report this information directly on the balance sheet or only in one of the notes to the statements.
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LO 3 DECISION CASE 4-2 READING AND INTERPRETING MCDONALD’S NOTES—REVENUE RECOGNITION
1. McDonald’s recognizes revenue from its company-operated restaurants on the cash basis of accounting. This means that revenue is recognized when cash is received from customers.
2. Continuing fees from franchised and affiliated restaurants are recognized in the period earned. This is in agreement with the revenue recognition principle that requires revenue to be recognized when it is earned.
3. McDonald’s recognizes initial fees from its franchised and affiliated restaurants when new locations are opened. This is in agreement with the revenue recognition principle that requires the company to perform substantially all of the initial services required by its agreement with the franchisee.
4. Franchise fees are a significant source of revenue to McDonald’s, amounting to $3,906.1 million in 2002. Given that total revenues amount to $15,405.7 million, franchise fees represent 25.4% of total revenues.
LO 3 DECISION CASE 4-3 READING AND INTERPRETING WINNEBAGO INDUSTRIES’ NOTES—REVENUE RECOGNITION
1. Winnebago Industries adopted SAB 101 “Revenue Recognition” as of the beginning of fiscal year 2001. This new accounting principle requires companies to recognize revenue when products are delivered to the dealer, which is when title passes. This may not necessarily be the same point in time as when the RVs are shipped to customers.
2. “Dealer Floor Plan Receivables” are amounts due to Winnebago Industries from sales of its RVs to select Winnebago, Itasca, Rialta and Ultimate dealers. Collateral for these receivables are in the form of the RVs that the company sells to the dealers.
3. Winnebago Industries earns two forms of revenue from these receivables. First, it earns revenue from the sale of the RVs, as described in 1. above. Second, the company earns interest income from the receivables. The interest is recorded on the accrual basis in accordance with the terms of the loan agreements Winnebago Industries has with its customers.
LO 3 DECISION CASE 4-4 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.
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2. Revenue to be recognized each year:
Year 1 Year 2 Year 3 TotalSales revenue $2,320* $ 0 $ 0 $ 2,320Service 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 ends of years 1 and 2, respectively, to report the amount of unearned revenue.
MAKING FINANCIAL DECISIONS
LO 2,3,4 DECISION CASE 4-5 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, 2004
Operating Activities:Cash received from services
provided to clients $ 1,020,000*Cash paid for:
Salaries and wages $ 440,000**Supplies 100,000Utilities 30,000Rent 180,000 *** 750,000
Net increase in cash $ 270,000
*$1,250,000 – $230,000
**$480,000 – $40,000
***$10,000 X 18 months
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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 2004, 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 2007. 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 X 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 4-6 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.
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ACCOUNTING AND ETHICS—WHAT WOULD YOU DO?
LO 2,3,4,5 DECISION CASE 4-7 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.
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 they depreciate 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
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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 4-8 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 $ 10,500Supplies 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.
FROM CONCEPT TO PRACTICE 4.1
McDonalds generated 25%, 26%, and 27% of its total revenues from franchised restaurants in 2002, 2001, and 2000 respectively. This percentage has remained relatively stable over the three-year period, although there has been a slight decrease in the company’s reliance on franchised restaurants as a form of revenue.
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FROM CONCEPT TO PRACTICE 4.2
Both Winnebago Industries and Monaco Coach classify their prepaid expenses as current assets. The types of prepaid expenses companies such as these might have include various prepayments, such as insurance and rent, and various types of supplies, such as cleaning and office supplies.
FROM CONCEPT TO PRACTICE 4.3
Winnebago Industries uses the term “accrued expenses” for its accrued liabilities. The individual accounts include: Accrued Compensation, Product Warranties, Insurance, Promotional, and Other. The largest of these is the Accrued Compensation account. Alternatively, Monaco Coach reports one line on its balance sheet titled “Accrued expenses and other liabilities.”
SOLUTIONS TO INTEGRATIVE PROBLEMS
Part 1
1. Effects on the accounting equation are as follows:
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MOUNTAIN HOME HEALTH, INC.RETAINED EARNINGS STATEMENT
FOR THE YEAR ENDED DECEMBER 31, 2003
Beginning balance $ 99,900Add: Net income 14,153Deduct: Dividends (10,000 )Ending balance $ 104,053
3. MOUNTAIN HOME HEALTH, INC.
BALANCE SHEETAS OF DECEMBER 31, 2003
AssetsCurrent assets:
Cash $ 77,400Billings receivable, net 167,000Medical supplies 8,653
Total current assets $ 253,053Property, plant, and equipment:
Building $ 200,000Less: Accumulated depreciation (60,000 ) 140,000
Total assets $ 393,053 Liabilities and Stockholders’ Equity
Current liabilities:Accounts payable $ 22,000Interest payable 3,000Salary and wages payable 4,000Dividend payable 10,000
Total current liabilities $ 39,000Long-term liabilities:
Mortgage payable 100,000 Total liabilities $ 139,000Stockholders’ Equity
Capital stock $ 100,000Additional paid-in capital 50,000Retained earnings 104,053
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
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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.
6. Supply of cash needed:
Salaries: $800 per day X 7 days per week X 7 weeks = $ 39,200Supplies: $1,500 per week X 7 weeks = 10,500Gasoline: $375 per day X 7 days per week X 7 weeks = 18,375 Supply of cash needed for 7 weeks = $ 68,075