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

Chapter 04
Adjustments, Financial Statements, and
the Quality of Earnings
ANSWERS TO QUESTIONS

1. A trial balance is a list of the individual accounts, usually in financial statement

order, with their debit or credit balances. It is used to provide a check on the
equality of the debits and credits.

2. Adjusting entries are made at the end of the accounting period to record all
revenues and expenses that have not been recorded but belong in the current
period. They update the balance sheet and income statement accounts at the end
of the accounting period.

3. The four different types are adjustments for:

(1) Deferred revenues -- previously recorded liabilities that need to be adjusted at
the end of the period to reflect revenues that have been earned (e.g., Unearned
Ticket Revenue must be adjusted for the portion of ticket revenues earned in
the current period).
(2) Accrued revenues -- revenues that have been earned by the end of the
accounting period but which will be collected in a future accounting period (e.g.,
recording Interest Receivable for interest revenues not yet collected).
(3) Deferred expenses -- previously recorded assets that need to be adjusted at the
end of the period to reflect incurred expenses (e.g., Prepaid Insurance must be
adjusted for the portion of insurance expense incurred in the current period).
(4) Accrued expenses -- expenses that have been incurred by the end of the
accounting period but which will be paid in a future accounting period (e.g.,
recording Utilities Payable for utilities expense incurred during the period that
has not yet been paid).

4. A contra-asset is an account related to an asset that is an offset or reduction to the

asset's balance. Accumulated Depreciation is a contra-account to the equipment
and buildings accounts.

4-1

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

5. The net income on the income statement is included in determining ending retained
earnings on the statement of stockholders’ equity and the balance sheet. The
change in the cash account on the balance sheet is analyzed and categorized on
the statement of cash flows into cash from operating activities, investing activities,
and financing activities.

6. (a) Income statement: Revenues (and gains) - Expenses (and losses) = Net Income
(b) Balance sheet: Assets = Liabilities + Stockholders' Equity
(c) Statement of cash flows: Changes in cash for the period = Cash from
Operations + Cash from Investing Activities + Cash from Financing Activities
(d) Statement of stockholders' equity: Ending Stockholders' Equity = (Beginning
Contributed Capital + Stock Issuances - Stock Repurchases) + (Beginning
Retained Earnings + Net Income - Dividends Declared)

7. Adjusting entries have no effect on cash. For deferred revenues and deferred
expenses, cash was received or paid at some point in the past. For accruals, cash
will be received or paid in a future accounting period. At the time of the adjusting
entry, there is no cash being received or paid.

8. Earnings per share = Net income ÷ average number of shares of stock outstanding
during the period.

Earnings per share measures the average amount of net income for the year
attributable to one share of common stock.

9. Net profit margin = Net income ÷ net sales

The net profit margin measures how much of every sales dollar generated during
the period is profit.

10. An unadjusted trial balance is prepared after all current transactions have been
journalized and posted to the ledger. It does not include the effects of the adjusting
entries. The basic purpose of an unadjusted trial balance is to check the equalities
of the accounting model (particularly, Debits = Credits) and to provide the data in a
form convenient for further processing in the accounting information processing
cycle.

In contrast, an adjusted trial balance is prepared after the effects of all of the
adjusting entries have been applied to the corresponding (prior) unadjusted trial
balance amounts. The basic purpose of an adjusted trial balance is to insure that
accuracy has been attained in applying the effect of the adjusting entries. The
adjusted trial balance provides a second check in the model equalities (primarily
Debits = Credits). It also provides data in a form convenient for further processing.

4-2

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

11. The closing entry is made at the end of the accounting period to (1) transfer the
balances in the temporary income statement accounts to retained earnings and (2)
reduce the revenue, gain, expense, and loss accounts to a zero balance so that
they can be used for the accumulation process during the next period. A closing
entry must be entered into the system through the journal and posted to the ledger
accounts to state properly the temporary and permanent account balances (i.e.,
zero balances in the temporary accounts).

12. (a) Permanent accounts -- balance sheet accounts; that is, the asset, liability, and
stockholders’ equity accounts (these are not closed at the end of each period).
(b) Temporary accounts -- income statement accounts; that is, revenues, gains,
expenses, and losses (these are closed at the end of each period).
(c) Real accounts -- another name for permanent accounts.
(d) Nominal accounts -- another name for temporary accounts.

13. The income statement accounts are closed at the end of the accounting period
because, in effect, they are temporary subaccounts to retained earnings (i.e., a part
of stockholders' equity). They are used only for accumulation during the accounting
period. When the period ends, these accumulated accounts must be transferred
(closed) to retained earnings. The closing process serves:

(1) to correctly state retained earnings, and

(2) to clear out the balances of the temporary accounts for the year just ended so
that these subaccounts can be used again during the next period for
accumulation and classification purposes.

Balance sheet accounts are not closed at the end of the period because they reflect
permanent accumulated balances of assets, liabilities, and stockholders' equity.
Permanent accounts show the entity's financial position at the end of the period and
are the beginning amounts for the next period.

14. A post-closing trial balance is a listing taken from the ledger after the adjusting and
closing entries have been journalized and posted. It is not a necessary part of the
accounting information processing cycle but it is useful because it demonstrates the
equality of the debits and credits in the ledger after the closing entry has been
journalized and posted and that all temporary accounts have zero balances.

4-3

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

ANSWERS TO MULTIPLE CHOICE

1. c
2. b
3. b
4. a
5. b
6. c
7. c
8. d
9. c
10. a

4-4

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

EXERCISES

E4–2.

Req. 1
Types Accounts to be Adjusted
Deferred Revenues:
Deferred Revenue may need to be Deferred Revenue (L) and Product
adjusted for any revenue earned Revenue and/or Service
during the period Revenue (R)

Accrued Revenues:
Interest may be earned on Short-term Interest Receivable (A) and Interest
Investments Revenue (R)

Any unrecorded sales or services Accounts Receivable (A) and

provided will need to be recorded Product Revenue and/or
Service Revenue (R)
Deferred Expenses:
Other Current Assets may include Other Current Assets (A) and
supplies, prepaid rent, prepaid Selling, General, and
insurance, or prepaid advertising Administrative Expense (E)

Any additional use of Property, Plant, Accumulated Depreciation (XA) and

and Equipment during the period Cost of Products and/or Cost
will need to be recorded of Services (E)

Accrued Expenses:
Interest incurred on Short-term Note Accrued Liabilities (L) and Interest
Payable and Long-term Debt will Expense (E)
need to be recorded

There are likely many other accrued Accrued Liabilities (L) and Selling,
expenses to be recorded, including General, and Administrative
wages, warranties, and utilities Expenses (among other
expenses) (E)

Income taxes must be computed for the Income Tax Payable (L) and
period and accrued Income Tax Expense (E)

Req. 2

Temporary accounts that accumulate during the period are closed at the end of the year
to the permanent account Retained Earnings. These include: Product revenue, service
revenue, interest revenue, cost of products, cost of services, interest expense, research

4-5
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
and development expense, selling, general, and administrative expense, other
expenses, and income tax expense.

4-6

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

E4–3.

Req. 1

The annual reporting period for this company is January 1 through December 31, 2011.

Req. 2 (Adjusting entries)

Both transactions are accruals because revenue has been earned and expenses
incurred but no cash has yet been received or paid.

(a) 1. Wages expense is incurred.

2. Cash will be paid in the next period to employees who worked in the current
period – an accrued expense needs to be recorded.
3. Amount: $7,000 given

Adjusting entry –
Wages expense (+E, −SE)........................... 7,000

Wages payable (+L).............................. 7,000

(b) 1. Interest revenue is now earned.

2. Cash will be received in the future – an accrued revenue needs to be
recorded.
3. Amount: $2,000 given

Adjusting entry –
Interest receivable (+A) ............................... 2,000

Interest revenue (+R, +SE)................... 2,000

Req. 3

Adjusting entries are necessary at the end of the accounting period to ensure that all
revenues earned and expenses incurred and the related assets and liabilities are
measured properly. The entries above are accruals; entry (a) is an accrued expense
(incurred but not yet recorded) and entry (b) is an accrued revenue (earned but not yet
recorded). In applying the accrual basis of accounting, revenues should be recognized
when earned and measurable and expenses should be recognized when incurred in
generating revenues.

4-7

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

E4–4.

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

Req. 2
Shipping Supplies is a deferred expense that needs to be adjusted at the end of the
period for the amount of supplies used during the period.
The amount is computed as follows: Beginning balance $11,000
Supplies purchased 60,000
Supplies on hand at end (20,000)
Supplies used $51,000
Adjusting entry:
Shipping supplies expense (+E, −SE) ........................ 51,000
Shipping supplies (−A) ..................................... 51,000

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

Shipping Supplies Shipping Supplies Expense

Beg. 11,000

Purch. 60,000
AJE 51,000 AJE 51,000

End. 20,000
End. 51,000

2011 Income statement:

Insurance expense $ 450
Shipping supplies expense $51,000

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

4-8

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

E4–5.
Balance Sheet Income Statement
Stockholders’ Net
Transaction Assets Liabilities Equity Revenues Expenses Income
E4–3 (a) NE +7,000 –7,000 NE +7,000 –7,000
E4–3 (b) +2,000 NE +2,000 +2,000 NE +2,000
E4–4 (a) –450 NE –450 NE +450 –450
E4–4 (b) –51,000 NE –51,000 NE +51,000 –51,000

E4–7.

Req. 1
a. Accrued revenue
b. Deferred expense
c. Accrued expense
d. Deferred revenue
e. Deferred expense
f. Deferred expense
g. Accrued expense

Req. 2 Computations
a. Accounts receivable (+A) ............................. 2,700 Given
Service revenue (+R, +SE)................. 2,700

b. Advertising expense (+E, −SE)..................... 900 $1,200 x 9/12 =

Prepaid advertising (−A) ..................... 900 $900 used

c. Interest expense (+E, −SE) .......................... 5,000 $250,000 x .12

Interest payable (+L) .......................... 5,000 x 2/12 (since last
payment) = $5,000
incurred

d. Unearned storage revenue (−L) ................... 750 $4,500 x 1/6 =

Storage revenue (+R, +SE) ................ 750 $750 earned

e. Depreciation expense (+E, −SE) .................. 22,000 Given

Accumulated depreciation (+XA, −A) 22,000

f. Supplies expense (+E, −SE)......................... 50,100 $16,500 +

Supplies (−A) ...................................... 50,100 $46,000 – $12,400
= $50,100 used

g. Wages expense (+E, −SE) ........................... 3,800 Given

Wages payable (+L) ........................... 3,800

4-9

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

E4–18.

Req. 1

(a) Insurance expense (+E, −SE) .................................... 4

Prepaid insurance (−A) .................................... 4

(b) Wages expense (+E, −SE) ......................................... 5

Wages payable (+L)......................................... 5

(c) Depreciation expense (+E, −SE) ................................ 8

Accumulated depreciation (+XA, −A) ............... 8

(d) Income tax expense (+E, −SE)................................... 9

Income tax payable (+L) .................................. 9

Req. 2
RED RIVER COMPANY
Trial Balance
December 31, 2011
(in thousands of dollars)

Unadjusted Adjustments Adjusted

Account Titles Debit Credit Debit Credit Debit Credit
Cash 35 35
Accounts receivable 9 9
Prepaid insurance 6 a 4 2
Machinery 80 80
Accumulated depreciation c 8 8
Accounts payable 9 9
Wages payable b 5 5
Income taxes payable d 9 9
Contributed capital 73 73
Retained earnings 4 4
Revenues (not detailed) 84 84
Expenses (not detailed) 32 a 4 58
c 8
b 5
d 9
Totals 166 166 26 26 188 188

4-10

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

PROBLEMS

P4–1.

Req. 1
Dell Inc.

Adjusted Trial Balance

At January 31, 2012

(in millions of dollars)

Debit Credit

Cash $ 8,352
Marketable securities 740
Accounts receivable 6,443
Inventories 867
Property, plant, and equipment 4,510
Accumulated depreciation $ 2,233
Other assets 7,821
Accounts payable 8,309
Accrued expenses payable 3,788
Long-term debt 1,898
Other liabilities 8,234
Contributed capital 11,189
Retained earnings (deficit) 9,396
Sales revenue 61,101
Other income 134
Cost of sales 50,144
Selling, general, and administrative expenses 7,102
Research and development expense 665
Income tax expense 846
Totals $ 96,886 $ 96,886

Req. 2

Since debits are supposed to equal credits in a trial balance, the balance in Retained
Earnings is determined as the amount in the debit column necessary to make debits
equal credits (a “plugged” figure).

4-11

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

P4–2.
Req. 1

a. Deferred revenue e. Deferred expense

b. Accrued expense f. Accrued revenue
c. Deferred expense g. Accrued expense
d. Deferred revenue h. Accrued expense

Req. 2

a. Unearned rent revenue (−L)......................................... 5,600

Rent revenue (+R, +SE)..................................... 5,600
($8,400 ÷ 6 months = $1,400 per month x 4 months)

b. Interest expense (+E, −SE) .......................................... 540

Interest payable (+L) ............................................ 540
($18,000 x .12 x 3/12)

c. Depreciation expense (+E, −SE).................................. 2,500

Accumulated depreciation (+XA, −A) .................. 2,500

d. Unearned service revenue (−L).................................... 500

Service revenue (+R, +SE) ................................. 500
($3,000 x 2/12)

e. Insurance expense (+E, −SE) ...................................... 1,500

Prepaid insurance (−A)...................................... 1,500
($9,000 ÷ 12 months = $750 per month x 2 months of coverage)

f. Accounts receivable (+A) ............................................. 4,000

Service revenue (+R, +SE) ................................ 4,000

g. Wage expense (+E, −SE)............................................. 14,000

Wages payable (+L) ........................................... 14,000

h. Property tax expense (+E, −SE)................................... 500

Property tax payable (+L)..................................... 500

4-12