Financial Accounting Excercise

Question Description

Resource: Ch. 4 of Financial Accounting

Complete Exercise BE4-1.

Complete Problems 4-2A & 4-3A.

Submit as either a Microsoft® Excel® or Microsoft® Word document.


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c04AccrualAccountingConcepts.qxd 8/3/10 1:50 PM Page 162 chapter 4 ACCRUAL ACCOUNTING CONCEPTS ✓ ● the navigator ● Scan Study Objectives ● Read Feature Story ● Scan Preview ● Read Text and Answer Do it! p. 175 p. 180 p. 185 After studying this chapter, you should be able to: p. 189 ● Work Using the Decision Toolkit ● Review Summary of Study Objectives ● Work Comprehensive Do it! p. 197 ● Answer Self-Test Questions ● Complete Assignments ● Go to WileyPLUS for practice and tutorials ● 162 study objectives Read A Look at IFRS p. 224 1 Explain the revenue recognition principle and the expense recognition principle. 2 Differentiate between the cash basis and the accrual basis of accounting. 3 Explain why adjusting entries are needed, and identify the major types of adjusting entries. 4 Prepare adjusting entries for deferrals. 5 Prepare adjusting entries for accruals. 6 Describe the nature and purpose of the adjusted trial balance. 7 Explain the purpose of closing entries. 8 Describe the required steps in the accounting cycle. 9 Understand the causes of differences between net income and cash provided by operating activities. c04AccrualAccountingConcepts.qxd 8/3/10 1:50 PM Page 163 feature story The accuracy of the financial reporting system de- most common abuses of financial accounting. Xerox pends on answers to a few fundamental questions. At admitted reporting billions of dollars of lease revenue what point has revenue been earned? At what point in periods earlier than it should have been reported. is the earnings process complete? When have ex- And WorldCom stunned the financial markets with its penses really been incurred? admission that it had boosted net income by billions During the 1990s, the stock prices of dot-com companies boomed. Many dot-com companies earned most of their revenue from selling advertising space on their websites. To boost reported revenue, some dot-coms began swapping website ad space. Company of dollars by delaying the recognition of expenses until later years. W HAT WAS YO U R P R O FIT? Unfortunately, revelations such as these have become all too common in the corporate world. It is no wonder that the U.S. Trust Survey of affluent Ameri- A would put an ad for its website on company B’s web- cans reported that 85 percent of its respondents be- site, and company B would put an ad for its website on lieved that there should be tighter regulation of finan- company A’s website. No money ever changed hands, cial disclosures, and 66 percent said they did not trust but each company recorded revenue (for the value of the management of publicly traded companies. the space that it gave up on its site). This practice did Why did so many companies violate basic financial little to boost net income and resulted in no additional reporting rules and sound ethics? Many speculate that cash flow—but it did boost reported revenue. Regula- as stock prices climbed, executives were under increas- tors eventually put an end to the practice. ing pressure to meet higher and higher earnings expec- Another type of transgression results from compa- tations. If actual results weren’t as good as hoped for, nies recording revenue or expenses in the wrong year. some gave in to temptation and “adjusted” their num- In fact, shifting revenues and expenses is one of the bers to meet market expectations. INSIDE CHAPTER 4 . . . ● ● ● ● Cooking the Books? (p. 166) Reporting Revenue Accurately (p. 167) Turning Gift Cards into Revenue (p. 174) Cashing In on Accrual Accounting (p. 178) 163 c04AccrualAccountingConcepts.qxd 8/3/10 1:50 PM Page 164 preview of chapter 4 As indicated in the Feature Story, making adjustments is necessary to avoid misstatement of revenues and expenses such as those at Xerox and WorldCom. In this chapter, we introduce you to the accrual accounting concepts that make such adjustments possible. The organization and content of the chapter are as follows. Accrual Accounting Concepts The Basics of Adjusting Entries Timing Issues • Revenue recognition principle • Expense recognition principle • Accrual versus cash basis of accounting • Types of adjusting entries • Adjusting entries for deferrals • Adjusting entries for accruals • Summary of basic relationships The Adjusted Trial Balance and Financial Statements • Preparing the adjusted trial balance • Preparing financial statements Closing the Books • Preparing closing entries • Preparing a postclosing trial balance • Summary of the accounting cycle Quality of Earnings • Earnings management • Sarbanes-Oxley Timing Issues study objective 1 Explain the revenue recognition principle and the expense recognition principle. Helpful Hint An accounting time period that is one year long is called a fiscal year. Revenue Recognition Service performed Customer requests service Cash received Revenue should be recognized in the accounting period in which it is earned (generally when service is performed). 164 Most businesses need immediate feedback about how well they are doing. For example, management usually wants monthly reports on financial results, most large corporations are required to present quarterly and annual financial statements to stockholders, and the Internal Revenue Service requires all businesses to file annual tax returns. Accounting divides the economic life of a business into artificial time periods. As indicated in Chapter 2, this is the periodicity assumption. Accounting time periods are generally a month, a quarter, or a year. Many business transactions affect more than one of these arbitrary time periods. For example, a new building purchased by Citigroup or a new airplane purchased by Delta Air Lines will be used for many years. It doesn’t make sense to expense the full cost of the building or the airplane at the time of purchase because each will be used for many subsequent periods. Instead, we determine the impact of each transaction on specific accounting periods. Determining the amount of revenues and expenses to report in a given accounting period can be difficult. Proper reporting requires an understanding of the nature of the company’s business. Two principles are used as guidelines: the revenue recognition principle and the expense recognition principle. THE REVENUE RECOGNITION PRINCIPLE The revenue recognition principle requires that companies recognize revenue in the accounting period in which it is earned. In a service company, revenue is considered to be earned at the time the service is performed. To illustrate, assume Conrad Dry Cleaners cleans clothing on June 30, but customers do not claim and pay for their clothes until the first week of July. Under the revenue recognition principle, Conrad earns revenue in June when it performs the service, not in July when it receives the cash. At June 30, Conrad would report a receivable on its balance sheet and revenue in its income statement for the service performed. The journal entries for June and July would be as follows. c04AccrualAccountingConcepts.qxd 8/3/10 1:50 PM Page 165 Timing Issues June July Accounts Receivable Service Revenue xxx Cash Accounts Receivable xxx 165 xxx xxx DECISION TOOLKIT DECISION CHECKPOINTS INFO NEEDED FOR DECISION TOOL TO USE FOR DECISION At what point should the company record revenue? Need to understand the nature of the company’s business Record revenue when earned. A service business earns revenue when it performs a service. HOW TO EVALUATE RESULTS Recognizing revenue too early overstates current period revenue; recognizing it too late understates current period revenue. THE EXPENSE RECOGNITION PRINCIPLE In recognizing expenses, a simple rule is followed: “Let the expenses follow the revenues.” Thus, expense recognition is tied to revenue recognition. Applied to the preceding example, this means that the salary expense Conrad incurred in performing the cleaning service on June 30 should be reported in the same period in which it recognizes the service revenue. The critical issue in expense recognition is determining when the expense makes its contribution to revenue. This may or may not be the same period in which the expense is paid. If Conrad does not pay the salary incurred on June 30 until July, it would report salaries payable on its June 30 balance sheet. The practice of expense recognition is referred to as the expense recognition principle (often referred to as the matching principle). It dictates that efforts (expenses) be matched with results (revenues). Illustration 4-1 shows these relationships. Illustration 4-1 GAAP relationships in revenue and expense recognition Periodicity Assumption Economic life of business can be divided into artificial time periods Revenue Recognition Principle Expense Recognition Principle Revenue recognized in the accounting period in which it is earned Expenses matched with revenues in the period when efforts are expended to generate revenues Revenue and Expense Recognition In accordance with generally accepted accounting principles (GAAP) c04AccrualAccountingConcepts.qxd 166 8/3/10 1:50 PM Page 166 chapter 4 Accrual Accounting Concepts DECISION TOOLKIT DECISION CHECKPOINTS INFO NEEDED FOR DECISION TOOL TO USE FOR DECISION At what point should the company record expenses? Need to understand the nature of the company’s business Expenses should “follow” revenues—that is, match the effort (expense) with the result (revenue). HOW TO EVALUATE RESULTS Recognizing expenses too early overstates current period expense; recognizing them too late understates current period expense. Ethics Insight Cooking the Books? Allegations of abuse of the revenue recognition principle have become all too common in recent years. For example, it was alleged that Krispy Kreme sometimes doubled the number of doughnuts shipped to wholesale customers at the end of a quarter to boost quarterly results. The customers shipped the unsold doughnuts back after the beginning of the next quarter for a refund. Conversely, Computer Associates International was accused of backdating sales—that is, saying that a sale that occurred at the beginning of one quarter occurred at the end of the previous quarter in order to achieve the previous quarter’s sales targets. ? study objective 2 Differentiate between the cash basis and the accrual basis of accounting. International Note Although different accounting standards are often used by companies in other countries, the accrual basis of accounting is central to all of these standards. What motivates sales executives and finance and accounting executives to participate in activities that result in inaccurate reporting of revenues? (See page 223.) ACCRUAL VERSUS CASH BASIS OF ACCOUNTING Accrual-basis accounting means that transactions that change a company’s financial statements are recorded in the periods in which the events occur, even if cash was not exchanged. For example, using the accrual basis means that companies recognize revenues when earned (the revenue recognition principle), even if cash was not received. Likewise, under the accrual basis, companies recognize expenses when incurred (the expense recognition principle), even if cash was not paid. An alternative to the accrual basis is the cash basis. Under cash-basis accounting, companies record revenue only when cash is received. They record expense only when cash is paid. The cash basis of accounting is prohibited under generally accepted accounting principles. Why? Because it does not record revenue when earned, thus violating the revenue recognition principle. Similarly, it does not record expenses when incurred, which violates the expense recognition principle. Illustration 4-2 compares accrual-based numbers and cash-based numbers. Suppose that Fresh Colors paints a large building in 2011. In 2011, it incurs and pays total expenses (salaries and paint costs) of $50,000. It bills the customer $80,000, but does not receive payment until 2012. On an accrual basis, Fresh Colors reports $80,000 of revenue during 2011 because that is when it is earned. The company matches expenses of $50,000 to the $80,000 of revenue. Thus, 2011 net income is $30,000 ($80,000 ⫺ $50,000). The $30,000 of net income reported for 2011 indicates the profitability of Fresh Colors’ efforts during that period. If, instead, Fresh Colors were to use cash-basis accounting, it would report $50,000 of expenses in 2011 and $80,000 of revenues during 2012. As shown in Illustration 4-2, it would report a loss of $50,000 in 2011 and would report net income of $80,000 in 2012. Clearly, the cash-basis measures are misleading because the financial performance of the company would be misstated for both 2011 and 2012. c04AccrualAccountingConcepts.qxd 8/3/10 1:50 PM Page 167 The Basics of Adjusting Entries 167 Illustration 4-2 Accrualversus cash-basis accounting 2011 Bob's Bait B arn arn Bob's Bait B Fresh Colors P AIN T P AIN T P $ Bob's Bait Barn $ Activity 2012 AIN T Purchased paint, painted building, paid employees Accrual basis Revenue Expense Net income Cash basis Revenue Expense Net loss $80,000 50,000 $30,000 $ 0 50,000 $( 50,000 ) Received payment for work done in 2011 Revenue Expense Net income $ Revenue Expense Net income $80,000 0 $80,000 $ 0 0 0 Investor Insight Reporting Revenue Accurately Until recently, electronics manufacturer Apple was required to spread the revenues earned from iPhone sales over the two-year period following the sale of the phone. Accounting standards required this because it was argued that Apple was obligated to provide software updates after the phone was sold. Therefore, since Apple had service obligations after the initial date of sale, it was forced to spread the revenue over a two-year period. However, since the company received full payment upfront, the cash flows from iPhones significantly exceeded the revenue reported from iPhone sales in each accounting period. It also meant that the rapid growth of iPhone sales was not fully reflected in the revenue amounts reported in Apple’s income statement. A new accounting standard now enables Apple to report nearly all of its iPhone revenue at the point of sale. It was estimated that 2009 revenues would have been about 17% higher, and earnings per share would have been almost 50% higher, under the new rule. ? In the past, why was it argued that Apple should spread the recognition of iPhone revenue over a two-year period, rather than recording it upfront? (See page 223.) The Basics of Adjusting Entries In order for revenues to be recorded in the period in which they are earned, and for expenses to be recognized in the period in which they are incurred, companies make adjusting entries. Adjusting entries ensure that the revenue recognition and expense recognition principles are followed. Adjusting entries are necessary because the trial balance—the first pulling together of the transaction data—may not contain up-to-date and complete data. This is true for several reasons: 1. Some events are not recorded daily because it is not efficient to do so. Examples are the use of supplies and the earning of wages by employees. study objective 3 Explain why adjusting entries are needed, and identify the major types of adjusting entries. c04AccrualAccountingConcepts.qxd 168 8/3/10 1:50 PM Page 168 chapter 4 Accrual Accounting Concepts International Note Internal controls are a system of checks and balances designed to detect and prevent fraud and errors. The Sarbanes-Oxley Act requires U.S. companies to enhance their systems of internal control. However, many foreign companies do not have to meet strict internal control requirements. Some U.S. companies believe that this gives foreign firms an unfair advantage because developing and maintaining internal controls can be very expensive. Illustration 4-3 Categories of adjusting entries 2. Some costs are not recorded during the accounting period because these costs expire with the passage of time rather than as a result of recurring daily transactions. Examples are charges related to the use of buildings and equipment, rent, and insurance. 3. Some items may be unrecorded. An example is a utility service bill that will not be received until the next accounting period. Adjusting entries are required every time a company prepares financial statements. The company analyzes each account in the trial balance to determine whether it is complete and up to date for financial statement purposes. Every adjusting entry will include one income statement account and one balance sheet account. TYPES OF ADJUSTING ENTRIES Adjusting entries are classified as either deferrals or accruals. As Illustration 4-3 shows, each of these classes has two subcategories. Deferrals: 1. Prepaid expenses: Expenses paid in cash and recorded as assets before they are used or consumed. 2. Unearned revenues: Cash received and recorded as liabilities before revenue is earned. Accruals: 1. Accrued revenues: Revenues earned but not yet received in cash or recorded. 2. Accrued expenses: Expenses incurred but not yet paid in cash or recorded. Subsequent sections give examples of each type of adjustment. Each example is based on the October 31 trial balance of Sierra Corporation, from Chapter 3, reproduced in Illustration 4-4. Note that Retained Earnings, with a zero balance, has been added to this trial balance. We will explain its use later. Illustration 4-4 balance Trial SIERRA CORPORATION Trial Balance October 31, 2012 Debit Cash Supplies Prepaid Insurance Equipment Notes Payable Accounts Payable Unearned Service Revenue Common Stock Retained Earnings Dividends Service Revenue Salaries Expense Rent Expense Credit $15,200 2,500 600 5,000 $ 5,000 2,500 1,200 10,000 0 500 10,000 4,000 900 $28,700 $28,700 We assume that Sierra Corporation uses an accounting period of one month. Thus, monthly adjusting entries are made. The entries are dated October 31. c04AccrualAccountingConcepts.qxd 8/3/10 1:50 PM Page 169 The Basics of Adjusting Entries ADJUSTING ENTRIES FOR DEFERRALS To defer means to postpone or delay. Deferrals are costs or revenues that are recognized at a date later than the point when cash was originally exchanged. Companies make adjusting entries for deferrals to record the portion of the deferred item that was incurred as an expense or earned as revenue during the current accounting period. The two types of deferrals are prepaid expenses and unearned revenues. study objective 169 4 Prepare adjusting entries for deferrals. Prepaid Expenses Companies record payments of expenses that will benefit more than one accounting period as assets called prepaid expenses or prepayments. When expenses are prepaid, an asset account is increased (debited) to show the service or benefit that the company will receive in the future. Examples of common prepayments are insurance, supplies, advertising, and rent. In addition, companies make prepayments when they purchase buildings and equipment. Prepaid expenses are costs that expire either with the passage of time (e.g., rent and insurance) or through use (e.g., supplies). The expiration of these costs does not require daily entries, which would be impractical and unnecessary. Accordingly, companies postpone the recognition of such cost expirations until they prepare financial statements. At each statement date, they make adjusting entries to record the expenses applicable to the current accounting period and to show the remaining amounts in the asset accounts. Prior to adjustment, assets are overstated and expenses are understated. Therefore, as shown in Illustration 4-5, an adjusting entry for prepaid expenses results in an increase (a debit) to an ...
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