inAccounting Timing AccruolsDeferrols: lsEverflhing und

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Been Here's WhereYou've

stotements in the of ln Chopter you studied quolities the informotion thefinonciol 2, occruol thot You informotion be useful. olsoleorned GAAPrequires Accounting should ore ond expenses moiched whenearned ore bosis occounting-revenues recognized to those revenues.

Goinq Here's WhereYou're

show stotements tronsoctions In Chopter vouwill leornmoreobouthow thefinonciol 3, hoppen ot of theexchonge goodsond services in whichtheexchonge thecoshond of deferrols ond dlfferent times. These occruols ore

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When you are finished studying this chapter, you should be able to: 1. Define accrual accounting and explain how income is measured' 2. Explain accruals and how they affect the fi.nancialstatements;describe and perform the adjustmentsrelated to accruals. 3" Explain deferrals and how they affect the financial statements;describe and perform the adjustmentsrelated to deferrals. 4. Construct the basic financial statementsfrom a given set of transactionsthat include accrualsand deferrals and recognize the effect of thesetransactionson actual financial statements. 5" Compute and explain working capital and the quick ratio. 6" Explain the businessrisks associatedwith financial records and accounting information.

97

98

CHA P T E3 . A C C R U AL S D D EF E R R ALS : R AN TTMTNrs E V E R vTH IN G A ccouN TtN G G tN

#ffng*s *F"{s"f{eys
When JohnRigas, former chairman the and CEO AdelphiaComof munications, was found guilty of bank and securities fraud and sentenced 15 yearsin prison,it was not just the caseof a CEO to who looted a publiclytraded communications company.John Rigas was the company's founder.He and his son,TimothyRigas, were convicted stealingover $2 billion from the company. of Somepeoplebelieve that havingsomeonelikethe founder of a companyas part of the managementteam will help protect the company from managementabuses. a firm's managers lf have some ownershipin the company, their interests shouldbe alignedwith thoseof the shareholders. Although there may be some truth in this, one thing is clearfrom the caseof Adelphia:Thereis no substitute ethicalbehavior. this case, for In the founder of the companydrove the companyinto bankruptcy support a life of exto treme luxury.For John Rigas, over 80 yearsold, the only luxury he may have left is the luxuryof spending the lastyearsof his life in jail.

[,.(].1 D ef ineac c r ual c o u n ti n g ac a n d ex plainhow in c o m ei s meas ur ed.

Measuring Income
After its first month, Tom's Wear prepareda set of financial statementsto measureand report the company's activity during that first month and to measureand report its financial position at the end of that month. Tom's Wear did both again for the secondmonth. At different points of time in the life of a company, owners, investors, creditors, and other interested parties want to know the company's financial position and accomplishments in order to make all kinds of evaluationsand decisions,including whether or not the company is meeting its goals. The main goal is usually to make a profit; so measuringthe profit the company has made during a specified period plays a big role in evaluating how successfully companyhas beendoing its busrness. a As you learnedin Chapter 2, the income statementsummarizesrevenuesand expenses for a period of time, usually a year. Net income can also be measuredfor a week, a month, or a quarter.For example,many companiesprovide quarterly financial information to their shareholders. That information would include net income for the quarter. Accountantsconsiderthe continuouslife of a business being composedof discretepeas riods of time-months, quarters,or years.The way we divide the revenuesand expenses among thosetime periodsis a crucial part of accounting. That is why timing is everythingin accounting. If revenueis earned (not necessarily collected)in a certaintime period, you must be sure that it is included on the income statementfor that period-not the one before and not the one after.Ifyou haveusedsomesuppliesduring a period,thenyou needto includethe costofthose suppliesas part of the expenses the income statement that sameperiod. on for Sometimesyou will seethe income statementreferred to as the staternent operof ations and other times as the profit and loss statement. However it is referred to, it will usually appearas the first financial statementin a company's annualreport. Exhibit 3.1 shows the income statements for Chico's FAS Inc. When you see total sales of for $1,404,575,000 the year ended January 28,2006, you know that all the salesmade in that fiscal year-a year of businessfor the company-are included in that amount, evenif some of the cashhas not been collectedfrom the customersby January 28,2006. Similarly, the expenses listed are only the expenses incurred in that fiscal year, whether or not the companyhaspaid for thoseexpenses January28,2006. Chico's has worked by hard to get the amountsright.

. I C H A P T E R 3 M E A S U R I N GN C O M E

99

EXHIBIT3.1 Chico's FAS,Inc. and Subsidiaries Consolidated Statements of Income

(ln thousands,except per share amounts)

lncome Statements for Chico's

Chico's had net salesof over $1.4 billion during the fiscal year ended January 28,2006. Investors dependon that information, so Chico's works hard to get it right.

Jan.uw28, 2006

Fiscal YearEnded January29, January 31, 2004 2005

Net sales by Chico's/Somastores Net sales by WHIBM stores Net sales by catalog and Internet Net salesto franchisees rNete ale s ,..,..., C ost o f go od ssold Gross profit General, administrative and store operating expenses Depreciation and amortization Income from operations .. Int ere stin co me,n et . Income before income taxes I nco meta xp rovisio n Netincome

. . $1,095,938 $ 889,429 $ 698,100 39,818 142,092 26I,601 26,831 22,780 .. 36,151 8,530 7,801 10,885 .. ....... 547,592 857,043 514,529 44,20I 298,313 8,236 306,549 112,568 $-193,981 411,908 654,974 297,477 471,022

.. . .. . ..... ..... ..

g__!4w

398,1 17 32,48r 224,376 2,827 226,703 85,497

289,118 21,130 160,774 888 16r,662 6r,432 $ 100,230

Timing differences in accounting are differencesbetween . the time when a company earnsrevenueby providing a product or serviceto customers and the time when the cash is collected from the customers, and . the time when the company incurs an expenseand the time when the company pays for the expense. You will seein this chapter how to identify timing differences and presentthem on the financial statements. As discussedin the previous chapter,you can think of the timing problems in accounting in two simple ways: . action before dollars . dollars before action An example of action before dollars is when a sale is made on account. A customer buys on credit and agreesto pay later. The action of making the sale-the economic substanceof the transaction-takes place before dollars are exchangedin payment. This type of transaction-action first, dollars later-is called an accrual. In contrast, an example of dollars before action is when a firm buys insurance.By its nature, insurance must be purchasedin advance of the time period to which it applies. Payment-when the dollars are exchanged-is made first, and the use of the insurancethe action provided by insuranceprotection-comes later. Dollars frst, action later is called a deferral. For timing differences,whether accrualsor deferrals,we must look at the accounting information on each side of the difference and adjust that information before it can be presentedon the financial statements.

arisewhen Timing differences are revenues earnedand collectedin different Theyalso accountingperiods. arisewhen expenses are incurredin one accounting period and paid for in another.

in An accrualis a transaction which the revenuehas been has earnedor the exoense been incurredbut no cashhas been exchanged. in A deferralis a transaction which the cashis exchanged beforethe revenueis earned is or the exoense incurred.

100

CHAPTER o ACCRUALS 3 AND DEFERRA L S :I M I N G l S E V E R Y T H I N GN A C C O U N T T N G T t

r c - i? Ex plain c r uals n d h o w ac a they affect the financial statements; describe and perform the adjustments relatedto accruals.

Accruals
When the substanceof a businesstransactiontakes place before any cash changeshands, the accountantincludes that transactionin the measurement income. That is, if a hrm has of earnedrevenue,that revenuemust be included on the income statement.If the firm incurred an expenseto earn that revenue,that expensemust be included on the income statement. Accruals can pertain to both revenuesand expenses. There are two types of accruals that needa closerlook: . interest expenseand interest revenue . other expensesand revenues

Accruals InterestExpense for and lnterestRevenue

The most common timing difference pertains to interest related to borrowing or lending money. When you borrow money, you pay interest for the use of that money. If you borrowed $500 from a bank on January 1,2006, and agreedto repay itwiths%o intereston January 1, 2007, yol would pay back a total of $540. On January1,2006, when you borrow the money, you get the $500 cash, an asset,and you increaseyour liabilities. The accounting equationis increased both sidesby $500. on

Assets

Liabilities

Shareholder's equity

Contributed capital + 500cash

* 500 notes oavable

Retained earnings

When you get ready to preparethe financial statementsfor the year ended December 31,2006, you seethat this liability-notes payable-is still on the books and will be listed on the balancesheet.That is becauseon December 3I,2006, you still owe the bank the full amount of the loan. What about the $500 cash you received?You may still have it, but it is more likely you spentit during the year to keep your business running. That is why you borrowed it. What about the cost of borrowing the money-the interest expense? December 31, On 2006, one full year has passedsince you borowed the money. The passing of time has causedinterest expenseto be incurred. . Interestexpense the cost of using someone is else'smoney. . Time passingis the action related to interest expense. Although the action of using someoneelse's money during the year has taken place, the dollars have not been exchanged-the interest payment for using that money. To make the December31,2006, financial statements correct, you must show the interestexpenseof $40 ($500 x 8Vo,or $500 x 0.08) on the income statement. Also, you must show-on the balancesheet-the obligation called interest payable. It is a liability, indicating the bank's claim to the $40 as of December31,2006. The liability sectionof the balancesheetwill show both the $500 loan and the $40 interest. Rememberthat revenuesand expensesare shown on the income statement.Then, before the balance sheetcan be prepared,net income needsto be added to the beginning retained earningsbalanceto get the new retainedearningsbalancefor the balancesheet.Even though revenuesand expenses eventually increaseretained earnings (part of shareholders' equity), theseamounts are not consideredpart of retained earnings.

lnterestpayableis a liability.tt is the amount a company owes for borrowing money (after the time periodto which the interestapplieshas passed).

Assets

Liabilities

Shareholder's equity

Contributed capital
l- 40 interest payable

Retained earnings
(40) interest expense

The adjustment increasesliabilities and will eventually decreaseretained earnings in the accountingequation.Making this adjustmentis called accruing interestexpense;the ex-

CHAPTER3. ACCRUALS

1 O1

penseitself is called an accmal. Sometimesa company will label the amount of interestexEach expressionmeansthe same penseaccruedas accrued liabilities or accrued expenses. thing-an expensethat will be paid in the future. Notice that the interest expensewill be on the income statementfor the period, even though the cash has not been paid yet. you borrowedthe $500 on July I,2006 (insteadof January1). In this case, Suppose you would have use of the money for only half of the year and therefore would have incurred only half a year of interest expenseas of December 31,2006. This is the formula for interest: Interest (I) = Principal (P) x Rate (R) x Time (T) Interestrates,like the 87o annualinterest,always pertain to a year.As of December31, 2006, the interest payable on the note would be $500 x 0.08 x 6112 : $20. The last part of the formula gives the time as a percentageof a year, or the number of months out of 12. Wheneveryou accrueinterest,you must be careful to count the months that apply. That will help you make sure you put the right amount of interest expenseon the income statement for exactly the period of time you had use of the borrowed money. If you borrowed the $500 on January I,2006, for one full year, what would happen when you pay the bank on January I, 2007? On one side of the accounting equation, you will reduce cash by $540. The equation witl be balancedby a reduction of $500 in notes payable plus the reduction of $40 in interest payable. There will be no expenserecorded when you actually pay the cash.Remember,the action has already taken place, and the action resulted in interest expensein 2006. There is no interest expensein2007 becauseyou paid off the loan on January l, 2007. This is how timing differences work. The expenseis recorded in one period, but the cash is paid in anotherperiod.

Assets

Liabilities

equity Shareholder's + Retained Contributed earnings capital

(540) cash

(40) interest payable (500) notespayable

In most of our examples,a company will be borrowing money; however, sometimesa company lends money to anothercompany or to an employee.A company that lends money accruesinterestrevenueduring the time the loan is outstanding.The amount of interestrevenue accrued at the time an income statementis preparedis calculated with the same formula used to calculateinterest expense,I = P x R x T. The amount of interestrevenuewill increaseassets-interest receivable-and will increaseretained earnings-via interestrevenue. Supposea company lends $200 to an employee on October I at ll%o interest, to be reassetspaid on January 1 of the following year. The transaction on October 1 decreases cash-and also increasesassets-other receivables.Becausefirms generally luseaccounts receivableto describeamounts customersowe the company,we call the amounts owed by others-meaning anyonewho is not a customer-other receivables.

Assets

Liabilities

Shareholder's equity

Contributed capital (200)cash + 200other receivables

Retained earnings

On December3 i, the company will accrueinterestrevenue.Why? Becausesome time has passedand interestrevenuehas been earnedduring that period. With interest,the action is the passage oftime, so the action has taken place, but the cash will not changehandsuntil the following January 1. You would record interest revenueof $5 ($200 x 0.\0 x 3/12).

102

lN T CHAPTER . ACCRUALS 3 AND DEFERRALS :I M I N G 1 5E V E R Y T H I N G A C C O U N T I N G

You would also record interest receivableof $5. By doing all this, the financial statements would accuratelyreflect the following situation on December 31: . The company has earned$5 of interest revenueas of December 31. . The company has not received the interest revenueat December 31. Becauseall revenuesincreaseretained earnings,the interest revenuewill be recorded under retained earningsin the accounting equation:

Assets

Liabilities

Shareholder's equity

Contributed capital
* 5 interest receivable

Retained earnings * 5 interest revenue

When the company actually receivesthe cash for the interest on January 1, along with repaymentof the $200 principal, it will not be recordedas interestrevenue.Instead,the toin tal $205 cashis recordedas an increasein cashand a decrease the assetother receivables by $200 and the assetinterest receivableby $5. The timing difference resulted in recording the interest revenuein one period and the cash collection in another.

Your Turn 3-l

"'l[i.l''..].l*,oi'slt' Ji'ilLu*tlu'

atTTo(interest ratesare alwaysassumed to 1. lf you borrowed$1,000 would you payfor having how muchinterest that money be peryear), for only 6 months? loanand you record interest expense be2. lf you havean outstanding payment the interest, this an acmakethe cash for is foreyou actually Why? crualor a deferral? and Accruals Other Revenues Expenses for
There are other types of revenuesand expensesthat must be accrued at the end of the pewill accuratelyreflect the businesstransactionsfor the riod so that the financial statements period. For example,ifyou have provided servicesfor a customerduring 2007 but have not recordedthose services(perhapsbecauseyou have not billed the customersyet), you want Why record this on the 2007 to be sureto record the revenueon the 2007 income statement. Becausethe action was completedin200T . You cannot record any cash income statement? received for this action in 2007-becatse you have not received payment in2007 as a result of your action in 2007. This is a timing difference, recorded as an accountsreceivable. Accrued revenueand receivablesare often paired together in accruals.An increasein assets-accounts receivable-and an increasein retained earnings-revenue-both in the sameamount, balancethe accountingequation.Then, when the cashis actually collectedsometimescalled realized-it is not recognized as revenuebecauseit was already recognized in a previous period. That is, receipt of the cashin the following year is not recognized as revenuebecausethe revenuewas already recognizedin the prior year. sectionofThlbots'balance sheet.At January28, Exhibit 3.2 showsthe current assets 2006, Talbots had accounts receivable amounting to $209,749,000.This is a significant amount of moneyl When you seereceivableson a company's balance sheet,it means the related revenueshave been earned and included on the income statementfor that period even though the cash has not been collected yet. When you get to the end of an accountingperiodExpenses may alsoneedto be accrued. transactions when you preparefinancial statements-you examineyour recordsand business to find any expensesthat might have been incurred but not recorded. These are the expenses you have not paid for yet. (If you paid for them, you would haverecorded them when you gave suchasutilities, you likely the cashto pay for them.)When you receivea bill for someexpenses will record the expenseand the relatedaccountspayable.Ifyou have done that, you will not need to accrue it at the end of the period. However, there are some typical expensesthat companiesdo not record until the end of the period. These expensesmust be accrued,which will result in an expenseon the in-

Realized meansthe cashis collected. Sometimes revenue is recognizedbefore it is realized.

C H A P T E3 . A C C R U A L S R

103

EXHIBIT3.2 The Talbots', Inc. and Subsidiaries From the Consolidated Balance Sheets
(Amounts thousands) in

Current AssetsSection of Talbots' BalanceSheet

This is the cuffent assetssection of Talbots' balance sheet.

Assets

January28, 2006

January29, 2005

CurrentAssets:
Merchandise inventories Deferred catalog costs . Due from affiliates Deferred income taxes Prepaid and other current assets Total current assets

246,707 238,544 6,02L 5,118 7,892 9,073 14,006 L4,ll5 29,589 33,t57 $ 620,661 $ 527,397

come statement and some sort of payable in the liabilities section of the balance sheet. These expenses have been recognized-shown on the income statement-but the cash has not been paid yet. One of the most common accrualsis salary expense.Typically, a company will record salary expensewhen it pays its employees. (In the accounting equation, that transaction would reduce assets-cash-and reduce retained earnings via salary expense.)What do you do ifthe end of an accountingperiod doesnot coincide with payday?Youneedto record the salary expensefor the work that your employeeshave done since the last time you paid them. You want to be sure to get the correct amount of salary expenseon the income statement for the period. This accrual will increaseliabilities-salaries payable-and decrease retained earningsvia salariesexpense.The action-the employeesperforming the workhas already taken place; but the cash will not be exchangeduntil the next payday, which will be in the next accounting period. for Supposeyou are preparing the financial statements the accountingperiod endedon If is on a Wednesday. you pay your employeesevery Friday, December31, 2008. That date the last paydayof the year is December26,2008. As of December31, 2008, you will owe them for their work done on Monday, Tuesday, and Wednesday,December 29, 2008, through December 31, 2008. You will need to record the salary expensefor those 3 days, even though you will not pay the employeesuntil Friday, January 2, 2009. Recording this salary expenseso it is recognized on the correct income statementis called accruing salary retained expense. This adjustmentwill increaseliabilities-salaries payable-and decrease earningsby increasing salary expense. What happens when January 2, 2009, arrives and you actually pay the employees?You pay them for the week from December 29, 2008, through January 2, 2009. The expense will for threeof thosedays-December 29 throughDecember31-was recordedon December31, for 2008, so that it would be on the income statement the fiscal year endedDecember3 1, 2008. l, 2009 and January 2, 2}O9-has not been The expense for the other 2 days-January recordedyet. The expensefor those 2 days belongs on the income statementfor the fiscal year on endedDecember3l,2009.When you pay the employees January2,2009, you will reduce payableyou recordedon December31, 2008, will be deliabilities-the amountof the salaries ducted from that account-and you will reduce retained eamings by recording salary expense for those2 daysin2009. Putting numbers in an example should help make this clear. Suppose the total amount you owe your employeesfor a 5-day workweek is $3,500.Look at the calendar in Exhibit 3.3-we are interestedin the week beginning December 29.

1o4

CHA P T E3 . AC C R U A L S D D EF E R R ALS : R AN TtMtN G E V E R vTH IN G A ccouN TtN G rs tN

EXHIBIT3.3 Calendarfor Accruing Salaries

If the frrm's fiscal year ends on December 31 and payday is every Friday, then salary expense for December 29. 30. and 3l must be accrued-even though it will not be paid to the employees until January 2.

Monday December22 December29 January 5

Ttresday December 23 December 30 January 6

Wednesday December 24 December31 January 7

Thursday December 25 Januaryl JanuaryS

FYiday December 26 January2 January9

On December 31, you need to accrue 3 days' worth of salary expense.The $3,500 applies to 5 days, but you need to look at it as $700 per day. To accruethe salary expensefor 3 days, you increasethe liability salariespayable and decrease retained earningsvia salary expenseby $2,100. Why are you recording the salary expenseand salariespayable even though you are not paying your employeesuntil January2? Becauseyou want to have the expensefor those 3 days on the income statementfor the year ended December 31, 2008. How does this adjustment affect the accounting equation?Both the income statementand the balance sheetare affected by this accrual.

Assets

Liabilities

Shareholder's equity Contributed + Retained capital earnings

+ 2,100
salaries payable

(2,100) salary
expense

On January 2, when you actually pay the employeesfor an entire week, you will give them cash of $3,500. How much of that amount is expensefor work done in the year 2008 and how much is expensefor work done in 2009? We already know that $2,100 is expense for 2008. The other 2 days' worth of work done and salary earned-91,400-applies to 2009. Here is how the transaction on January Z-paying the employeesfor a full week of work-affects the accounting equation: Cashis reduced;salariespayableis reduced;and retainedearningsis reducedvia salary expense. Liabilities Shareholder's equity

Contributed capital

Retained earnings

(3,500)
cash

(2,100) salaries
payable

(1,400)
salary expense

Review the example and make sureyou know why the adjustmenton December31 was necessaryand how the amount was calculated.Notice that the salary expenserecorded is only the amount of the Januarywork.

qrs-' Wffiff ".ffimpw*gw

Your Turn 3-2

paysits employees total of $56,000 the 1sth Suppose Company ABC a on of eachmonthfor work donethe previous generally month.ABC records salary when the employees paid.lf the ABCfiscalyear-end expense are is June30, 2008,doesany salaryexpense needto be accrued yearat end?lf so,how much?

[""{}.3 Ex plain er r als n d h o w def a they affect the financial statements; describe and perform the adjustments relatedto deferrals.

Deferrals
The word defer means"to put off or to postpone."[n accounting,a deferralrefers to a fransaction in which the dollars havebeenexchanged before the economic substance the transaction-the of action-has taken place. It can refer to both revenuesand expenses. you read and study the As examplesthat follow, rememberthat you are taking the point of view of the business.

C H A P T E3 . D E F E R R A L S R

105

Deferrals Relatedto Revenue

Unearned Revenue. Supposea company decidesto sell items on the Internet. The man who owns the company is a conservativefellow who is not too sure about this way of doing business,so he decides that he will not ship the products until he has received a customer's check and it has clearedthe bank. When the company receivesa check for $80 for an order, the owner must defer recognition of the revenue until the items have shipped. However, he immediately deposits the check. Technically, he does not have claim to the cash until he ships the items he sold. In fact, the claim to the cash belongs to the customer at the time the company receivesand depositsthe check. Here is how this cash receipt affectsthe accounting equalion:

Assets

Liabilities

equity Shareholder's Contributed + Retained earnings capital

A deferral is a transaction i n w hi ch the cashi s received paid before the or action takes place.The cash must be recorded,but recognitionof the related revenueor expenseis deferred.When we adjust that deferralto recognize any portion that may no longer need to be deferred, w e are real l yundoi nga deferral.

t 80 cash

t 80 unearned revenue
Unearnedrevenueis a liability.lt represents the amount of goodsor services that a companyowes its The customers. cashhas been but the action of collected, earningthe revenuehas not taken place.

amountsa company Unearned reyenue is a balancesheetaccount-a liability. It represents becausethe company is putting offthe owes to others-customers. This is called a deferral recognition of the revenue,that is, not showing it on the income statementuntil the revenue is actually earned.Pleasenotice that the name of this liability is a bit unusual. It has the word revenuein it, but it is not an income statementaccount. When the items sold are actually shipped, the company will recognize the revenue. This will be done by decreasingunearnedrevenueand increasingretained earningsvia revenue. Here is how the accounting equation will be affected:

Assets

Liabilities

(80) unearned revenue

equity Shareholder's Contributed + Retained earnings capital 80 sales revenue

Notice that the claim has changed hands-the claim no longer belongs to the customer. Now that the items have been shipped, the owner has claim to the $80 cash paid by the customer. Another common example of deferred revenueis magazine subscriptions.Customers pay the company in advance,so the dollars are exchangedbefore the action-delivery of the magazine-takes place. When the customerspay, the cash must be deposited,but the revenueis not recognized.If the magazine company preparesa balance sheetafter receiving the cash but before the magazines are actually delivered (the revenue has not been earned), the balance sheet will show the cash and the obligation to the customersunearnedrevenue.That obligation will be removed from the balance sheetwhen the magazinesare delivered. The current liabilities sectionof the balancesheetfor Time WarnerInc. at December31, 2005 and 2004, ne shown in Exhibit 3.4. Highlighted on the statementyou will see$1,473 million of unearnedrevenueat the end of 2005 and $1,653 million at the end of 2006. The company calls it deferred revenue.It representsamounts Time Warner has collected from customersbut has not yet earnedby providing the related services.As the company earns those revenues,the earned amounts will be deductedfrom the liability and recognized as revenue. Gift Certificates. Have you ever received a gift certificate or a gift card?Almost all retail firms are happy to sell gift cards. Supposeyou decide to purchasea $50 gift card at Best Buy to give your cousin for his birthday. You want somethingeasyto mail, and you are not surewhat sort of gift he would like. When you pay $50 to Best Buy for a gift card, Best Buy records the cash-an asset-and a liability-unearned revenue.Some firms combine their

10 6

cHAPTER3 . ACCRUALS AND DEFERRA L S :t M t N G t s E V E R y T H I N GN A c c o u N T t N G T t

EXHIBIT3.4

Deferred Revenue from TimeWarner, Inc.

Time Warner has had over a billion dollars of deferred revenueat the end of each of the past two years, highlighted in the portion of its balancesheet shown here.

Time Warner Inc. FYomthe Consolidated Balance Sheet December31,

(millions)

Liabilities and Shareholders' Equity Current liabilities Ac c ount s pay abl e Participationspayable Royalties and programming costs payable Deferredrevenue .. Debt due within one year Other current liabilities Current liabilities ofdiscontinued operations Totalcurrentliabilities

...... ..

$ 1,380 2,426 I,074 1,473

$ 1 ,3 3 9

2,452
1,018 1,653

92
.. 6,100 43 $12.588

1,672 6,468
50 $L4.652

liability for gift cards with other liabilities on their balance sheet.Others have such a significant amount that the liability for gift cards is shown as a line item on the balance sheet. Look at Best Buy's balance sheetin Exhibit 3.5. You will seethe liability unredeemedgift cards for $469 million at February 25,2006. As the gift cards are redeemedor as they expire, Best Buy will rccognize the related revenue.

EXHIBIT3.5

Liabilities from Best Buy'sBalance Sheet

The highlighted line shows that Best Buy had a significant amount of outstanding gift cards at the end of each of the fiscal years shown.

BestBuy Co.,Inc. Consolidated BalanceSheets

($ in millions)

February25, 2006

February26, 2005

Liabilities and Shareholders' Equity Current Liabilities Accounts Accrued compensation and related expenses Accrued liabilities Accrued income taxes Currentportion oflong-term debt . . Total current liabilities Long-Term Liabilities Long-TermDebt . Shareholders' Equity Preferred stock, $1.00par value: Authorized-400,000 shares; Issued and outstanding-none . Common stock, $.10 par value: Authorized-l billion shares; Issued and outstanding-485,098,000 and.492,512,000 shares; respectively Additional paid-in capital Retained eamings Accumulated other comprehensive income Total shareholders'equity Totalliabilities and Shareholders'Equity

703 4r8 6,056 373 178

575 72 4,959 358 528

49
643 4,304 26I 5,257 $ 11,864

49 936 3,315 r49 4,M9 $ 10,294

. CHAPTER3 DEFERRALS

1 O7

Living Time Magazine collected $300,000for 12-month subscriptions before it published its first issue in June 2008. How much revenue should the magazine company recognize for the fiscal year ended December31,2008?Explainwhat it meansto recognizerevenue in this situation.

Your Turn 3-3

Tws*ar We-s'sm

Deferrals Relatedto Expenses

Four kinds of expensesare commonly paid in advance.We will first discussexpenses for insurance,rent, and supplies.The other is an advancepayment for equipment used by a company for more than one fiscal period. All four expenseshave in common that the timing of the cash disbursementprecedesthe actual use of the product or service purchased. Insurance. Like any of us when we buy insurance,a company pays for insurancein advance of the service provided by the insurancecompany. In accounting, the advancepayment for a service or good to be received in the future is considered the purchase of an prepaid insurance.Remember, asset.Recall from Chapter 2 that accountantscall the asse't assetsare items of value that the company will use up to produce revenue.Until it is actually used,prepaid insuranceis shown in the current assetsection ofthe balancesheet.Suppose a firm paid $2,400 for 1 year of insurancecoverage,beginning on October 1, the date of the payment to the insurance company. Here is how the payment would affect the accounting equation:

Assets

Liabilities

equity Shareholder's Contributed + Retained earnings capital

(2,400) cash + 2,400prepaid insurance

Purchasingthe insurancepolicy is an assetexchange:Cash is exchangedfor prepaid inthe surance. expense recordedwhen the paymentis madebecause benefit of the cost No is has not been used.The expensewill be recognizedwhen the company actually usesthe insurance.The signal that the insuranceis being used is the passing of time. As time passes,the insurance protection expires and the amount paid for insurance during that time becomes an expense.The firm makes the adjustment when it preparesthe financial statements. on Supposethe firm wants to preparethe financial statements December31. How much of the insurance is still unused?That is the amount the firm must show as an asseton the December3l balancesheet.How much hasbeen usedup? That is the amount the firm must show as an expenseon the income statement.

i--postponing recognition that of means that deferring expense an I Vo, havelearned in Fannie expense-keepingoff the income it until statement sometime the future. provider funding homemortgages, isexpected recognize to about Mae, giant a for of I Oops! May2006, In Fannie Mae 11 billion losses hadbeen deferred of that erroneously $ partof a settlement accounting-fraud of agreed paya $400million to theSEC as to fine charoes.

I I I I

108

I T AND DEFERRAL S :I M I N G I S E V E R Y T H I N GN A C C O U N T I N G CHAPTER . ACCRUALS 3

Here is the adjustment the firm makes before preparing the December 31 financial statements: Assets = Liabilities

equity Shareholder's Contributed capital

Retained earnings

(600) prepaid lnsurance

(600) lnsurance expense

The firm has used up 3 months of the l2-month insurance policy already paid for. The firm paid $2,400 for the l2-month policy, so the monthly cost of insurance is $200. That means the total insurance expense for 3 months is $600, and the prepaid insurance remaining-insurance not yet usedup-will be on the December31 balancesheetin the amount of $1,800.Look at Exhibit 3.6 for anotherexamplewith insurance. Rent. Rent is also usually paid in advance. In the accounting records, prepaid rent is treated exactly the same way as prepaid insurance.When the company pays the cash for rent in advance,an assetcalled prepaid rent is recorded.The disbursementof cashfor prepaid rent is an assetexchange.Supposea company paid $9,000 to rent a warehousefor 3 months, beginning on November 1, the date of the payment. The way it would affect the accounting equation follows:

Prepaidrent is an asset.lt amountspaid for represents rent not yet used.The rent is expense deferreduntil the rented assethas actuallybeen used-when the time related to the rent has oassed.

Assets

Liabilities

equity Shareholder's Contributed + Retained earnings capital

(9,000) cash + 9,000prepaid rent

Notice, no expenseis recognized prepaid rent is increased,and cashis decreased. The asset when the company makesthe payment for the rent. Until it is actually used, prepaid rent is an asset.When would the rent expensebe recognized,that is, when would it be put on the it When the company preparesfinancial statements, wants to be surethat income statement? the rent expenseis shown correctly on the income statement.The amount paid was $9,000 are for a period of 3 months, which is $3,000 per month. When the financial statements prepared on December 3 1, 2 months of rent has been used-$6,000. To make surethe income statementreflects the expensefor the period ended December 31, the company makes the following adjustment:

EXHIBIT3.6

DeferredExpenseslnsurance

$500 cash paid tor insurance policyat the beginning 2007 ot for coverageover two yeats,2007 and 2008:

expenseon the income lnsurance statementsto( 2007 and for 2008:

. CHAPTER3 DEFERRALS

109

Assets

Liabilities

Shareholder's equity Contributed capital + Retained earnings

(6,000)
prepaid rent

(6,000)rent expense

That Notice that rent expenseis shown as a reduction in retainedearnings,like all expenses. leaves 1 month of rent, $3,000, on the balance sheet as prepaid rent. The rent expensefor November and December-$6,000-will be shown on the income statementfor the year endedDecember31.

paid the annualrent on its new office space Advantage on Company March1.Thetotal for a yearof rentwas $3,500. How muchrentexpense would be shownon the Advantage statement? December income 31
Supplies. Suppliesare commonly purchased advance. companybuying suppliesis A in exchanging one assetfor another.The cost of the supplies is not recognized as an expense until the supplies are actually used. Supposea company startedMarch with no supplies on hand and purchased$500 worth of suppliesduring the month. Here is how the purchaseaffects the accounting equation:

Your Turn 3-4

$'ku-+lsw'. . wwgm
In general, supplies not are inventory. ies called Suppl aremiscellaneous items When usedin the business. purchased, supplies are recorded an asset. as Supplies expense is recognized afterthe supplies used. are lnventory isa term reserved the for purchases items company a to resell,

Assets

Liabilities

Shareholder's equity

Contributed capital (500)cash * 500supplies

Retained earnings

If monthly financial statements prepared,the companywill count the amount of unare used supplies on March 31 to get the amount that will be shown as an asseton the March on 31 balancesheet. will be an asset that date.The difOnly the amountof unusedsupplies ference between the amount available to use during March and the amount remaining on March 31 is the amount of supplies that must have been used. This amount, representing suppliesused, will be an expenseon the income statement. Supposethe company counts the supplieson March 31 and finds that there is $150 worth of supplies left in the supply closet. How many dollars worth of supplies must have beenused?$500 of supplies handminus $150 supplies used. on remaining: $350 supplies After supplieshave been counted,the company must make an adjustmentto get the correct amounts for the financial statements. This is the necessaryadjustment:

Assets

Liabilities

Shareholder's equity

Contributed capital

Retained earnings

(3s0)
supplies

(3s0) supplies
expense

That will leave $150 for the amount of suppliesto be shown on the March 31 balancesheet. The income statementfor the month of March will show $350 in supplies expense. Supposethat during April the companypurchases additional $500 worth of supan plies. Then, on April 30 as the company is preparing financial statementsfor April, the supplies left on hand are counted. If $200 worth of supplies are on hand on April 30, what adjustmentshould be made?Recall that at the end of March, there were $150 worth of supplies on hand. That means that April started with those supplies. Then $500 worth of supplieswere purchased. That meansthat the companyhad $650 of suppliesavailableto

110

CHAPTER . Ac CRUALSAND DEFERRAL S :T M T N Gs E V E R y T H I N GN A c c o u N T t N G 3 T r t

EXHIBIT3.7 Deferred Expenses-Supplies

March $50 worthof supplies used Costof supplies used in March will be on the incomestatement as supplies expense of $50for the monthof March. Supplies expense Aprilwill for be $30.

IIIIT
April Supply Closet $30 worth of supplies used

rlll TIITI IIIII ITTII TTIII

t rr
$40 worthof supplies used Supplies expense Maywill for be $40.

T III
$20 worthof supplies used Supplies expense Junewill for be $20.

IT
$30 worthof supplies used Supplies expense Julywill for be $30.

r lI
February Company 1: buys$240worthof supplies and payscash. Thiswillbe on the statement of cash flows, putsthe supplies Company in the supplycloset. The cost of the supplies recorded is as an asseton the balancesheet. The company has something of value.Dollars havebeen exchanged beforethe action of usingthe supplies has taken place. This is a deferral: dollars first,actionlater. As supplies used,the are costof thoseusedbecomes supplies expense willbe and on the income statement as an expense the in periodthe supplies are useo. Thereare $70 worthof supplies the supply in closetat the end of July. Thatamountwill remain on the balance sheetas an assetuntilthe supplies used. are

use during April. What dollar amountof supplieswas actuallyused?Because9200 worth of suppliesare left, the company must have used 9450 worth of suppliesduring April. The adjustmentat the end of April would reduce the assetsuppliesby $450 and would reduceretainedearningsby $450 via suppliesexpense. Check out Exhibit 3.7 for another example of deferring supplies expense.

Your Turn 3-s '".u\*0fr*$ffi,,tt*

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Konnycompany started Aprilwith $500 worth of supplies. Duringthe month, Konnypurchased worth of supplies. the end of April, supplies $650 At on handwere counted, and $250worth of supplies was left. 1. What amountof supplies would Konnyput on its balance sheetat A pril30? 2. What amountof supplies expense would appear its income on statementfor the monthof April?
Equipment, When a companypurchases assetthat will be usedfor more than one acan counting period, the cost of the assetis not recognizedas an expensewhen the assetis purchased.The expenseof using the assetis recognized during the periods in which the asset is used to generaterevenue.When a firm buys an asset-such as a computer or office furniture-it will record the purchaseas an asset.It is an assetexchangebecausethe flrm is exchangingone asset-cash-for anotherasset-equipment. Then, the hrm will recognize

. C H A P TE R 3D E FE R R A LS 111 a portion of that equipment cost each accounting period in which the equipment is used, hopefully to generaterevenue. The matching principle is the reasonthe cost of equipmentis spreadover severalperiods. Expensesand the revenuesthey help generateneed to be on the same income statement-that is the heart of the matching principle. When it is hard to make a precise match with specific revenue(such as salesand cost of goods sold), the next best match is to put an expenseon the income statementin the period in which the related assetis used. That is what you do with equipment-allocate the cost of the equipment to the periods the equipment is used. Supposea companypurchases computerfor $5,000 cash.When the purchaseis made, a the company will record the acquisition of the new assetand the cash payment.

Assets

Liabilities

Shareholder's equity

Contributed capital (5,000) cash + 5,000computer

Retained earnings

If the firm were to classify the purchaseas an expenseat this point, it would be doing a very poorjob of matching revenuesand expenses. The firm wants to recognize the expenseof the computer during the years in which it usesthe computer. The terminology that accountants with equipment is different than the terminology use usedwith other deferrals.Insteadof calling the expense related to using the computer something logical like "computer expense,"it is called depreciation expense. Do not confuse depreciationin this accounting context with depreciationcommonly used to mean decline in market value. As the assetis used and the firm wants to reduce its amount in the accountingrecords, the accountantwill not subtractthe amount of the expensedirectly from the asset'spurchase price. Instead, per GAAP, the firm will show the subtractions separatelyon the balance sheet.Exhibit 3.8 showshow Best Buy Co. Inc. presents this information. Using real financial information to first learn an accounting concept can be difficult. An examplewith a fictitious company will help explain the accountingtreatmentof the cost of equipmentand its depreciationexpenseover time. SampleCompany purchasedthe computer for $5,000 on January l, 2009, and recordedthe assetexchangeshown in the preceding accounting equation. Then, when Sample Company prepares its year-end financial statements, depreciationexpensemust be recognized.The shareholders'claims to the company assetsare reduced via depreciationexpense. To calculate how much the assetcost should be reduced each year, Sample Company first must deduct the value it believesthe assetwill have-what it will be worthwhen the company is finished using it. That amount is called the residual value. In this example, Sample Company plans to use the computer until it is worth nothing; that means the residual value is zero. The cost of the assetminus any residual value is divided by the number of accountingperiods that the assetwill be used.Usually, the time period for depreciationexpenseis a year. BecauseSampleplans to use the $5,000 computer for 5 years and has estimatedits residual value to be zero, the annual depreciation amountwill be $1,000. The total reduction in the dollar amount of equipment, at any particular point in time, is called accumulated depreciation. Each year, accumulateddepreciationgets larger.Accumulated depreciationis not the sameas depreciationexpense.Accumulated depreciation is the total depreciationtaken over the entire life of the asset,and depreciation expenseis the amount of depreciationfor a single year. Accumulated depreciationis called a contraasset becauseit is the opposite of an asset.It is a deduction from assets. Accumulated depreciation is disclosedseparatelysomewherein the financial statements that the original so cost of the equipment is kept intact. On the balance sheet,the original cost of the equipment is shown along with the deduction for accumulated depreciation-the total amount of depreciation that has been

The depreciationexpense is the expense eachperiod. for

Residual value,alsoknown as salvagevalue, is the estimated value of an asset the end of at its usefullife. With most depreciation methods, residual value is deducted beforethe calculation of depreciation expense. The accumulateddepreciation is the reductionto the costof the asset. Accumulated depreciation a contra-asset, is deductedfrom the costof the asset the balance for sheet. A contra-assetis an amount that is deductedfrom an

112

lN T AND DEFERRAL S :I M I N G l S E V E R Y T H I N G A C C O U N T I N G CHAPTER . ACCRUALS 3

EXHIBIT3.8

Assetsfrom BestBuy's Balance Sheet

Best Buy has property and equipment that cost $4,836 million on February 25,2006. The total amount of depreciation expensethe firm has recorded is over the life of theseassets $2.124million.

BestBuy Co.,Inc. BalanceSheets Consolidated

($ in millions)

Assets Current Assets Cash and cash equivalents Short-term investments Receivables Merchandise inventories Other current assets Total current assets Property and equipment Land and buildings Leasehold improvements

February 25, 2006

February 26, 2005

....

681 3,051 506 3,338 409 7,985 580 r,325 2,898 33

354 2,994 2,851 329 6,903 506 1,139 2,458 89

Goodwill Tladename Long-term investiments Other assets Tota] assets

557 44 2t8 348 $ 11,864

513 40 148 226 $ 10,294

The book value of an assetis the cost minusthe accumulated depreciation relatedto the asset. Carryingvalue is another expression book value. for

recordedduring the time the assethas been owned.The resulting amount is called the book value, or carrying value, of the equipment. The book value is the net amount that is included when the total assetsare addedup on the balance sheet. Here is the year-end adjustment to record depreciation of the assetafter its first year of use:

Assets

Liabilities

Shareholder's Contributed + Retained earnings capital

(1,000)
accumulated depreciation

(1,000)
depreciation expense

The accumulateddepreciation is shown on the balance sheetas a deduction from the cost of the equipment. The depreciation expenseis shown on the income statement.The book value of the assetis $4,000 (cost minus accumulateddepreciation) at the end of the first year. After the secondyear of use, Sample Company would again record the same thing$1,000 more recorded as accumulated depreciation and $1,000 as depreciation expense. The amount of accumulateddepreciationwill then be $2,000. The amount of depreciation expenseis only $1,000 becauseit representsonly a single year-the secondyear-of depreciation expense.The accumulateddepreciationrefers to all the depreciationexpensefor the life of the assetthrough the year of the financial statement.The book value of the computer at the end of the secondyear is $3,000-$5,000 cost minus its $2,000 accumulated deoreciation.SeeExhibit 3.9 for anotherexample.

A S CHAPTER . EFFECTO F A C C R U A L S N D D E F E R R A LO N F I N A N C I A L T A T E M E N T S 3 S S Truckourchased on January ,2007.The 1 truckwill last for seven years.Cost is $49,000. No residual value. Cost of the truckwill be soreadoverthe incomestatements the sevenyearsthe of truck is used as depreciation expense.The expenseis being deferred,thalis put off, untilthe truck is actuallyused. The cost of the assef is spread-as an expens#venly example) over the life of the asset. (in this

113

EXHIBIT3.9 Deferred ExpensesDepreciation

gs
Year ended December 31 Depreciation expense Accumulated deoreciation

2007 2010 2011 2012 2008 2009 2013 $ 7 ,0 0 0 $ 7 ,0 0 0 $ 7 ,0 0 0 $ 7,000 $ 7,000 $ 7,000 $ 7,000 $7,000 $14,000$21 ,000 $28,ooo $35,000 $42,000 $49,000

q'-@ 6*@ &slffi Wt& q5--t@ Sts$

TangoCompany purchased computer July 1,2006,for $5,500. is a on lt expected lastfor 5 yearsand havea residual to valueof $500at the end of the fifth year.How muchdepreciation would appear the expense on Tango December 31,2006, income What is the bookvalueof statement? the computerat the end of 2OO7?

Your Turn 3-6

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Effects Accruals Deferrals of and on Financial Statements

Now that you have learnedthe details of accrual and deferralsyou are ready to put it all together in the construction of a set of financial statements. will take Tom's Wear through We its third month of businessto see how timing differences affect the firm's financial statements. Then we will look at some real firms' financial statementsto identify the effects of accrualsand deferrals.

I-.$.4 C onstruct the basi c na ncial fi statements from a given set of transacti ons that i nclude accrual s and deferral s nd a recognize the effect of thesetransactions actual on financialstatements.

Tom's WearTransactions March for

In ChaptersI and2, Tom's Wear completedits first two months of operations.Exhibit 3.10 shows the company's balance sheetat the end of the secondmonth, which we preparedin Chapter 2.

E X Ht B t T . 1 0 3
Tom's Wear, Inc. Balance Sheet At February 28,2006
Liabilities and Shareholder's equity Cash Accounts receivable Inventory Prepaid insurance

Tom'sWear BalanceSheet at February28,2006

$ 6,695 150 100 125

Ac c ou n t s p a y a b l e O t her p a y a b l e s . . . . Common stock Retained earnings Total liabilities and shareholder's equlty

.......

800 50 5,000 r,220

t0m'sweal

T otala ssets

........

$7, 070

$ 7,070

114

lN T CHAPTER . ACCRUALS 3 AND DEFERRAL S :I M I N G l S E V E R Y T H I N G A C C O U N T I N G

EXHIBIT3."I1 Transactions March for 2006 for Tom's Wear

l March I

2 March 10 3 March 15 4March20 5March24 6March27

Purchased computer for $4,000with $1,000down and a 3-month, l2o/onotefor $3,000.The computer is expected to last for 3 years and have a residual value of $400. Paid the rest of last month's advertising biII, $50. Collected accounts receivable of $150from customers from February. Paid for February purchases-pa)"ng off the accounts payable balance of $800. Purchased 250 shirts @ $4 each for cash, $1,000. SoId 200 shirts for $10 each, all on account, for total sales of $2,000.

These are the amountsthat are carried over to the next month, so this is the March I,2006, balancesheet,too. We will now take Tom's Wear through the third month of business,with shownin Exhibit 3.11. the transactions At the end of his third month, Tom prepareshis financial statementsto see how his businessis progressing.We will seehow each transaction affects the accounting equation. Then, look at the accounting equation worksheet in Exhibit 3.12 at the end of the example to seeall ofthe transactionstogether. Transaction l: Purchase of a long-term assel Tom's Wear purchasesa fixed assetthat will last longer than 1 year; therefore, it will be classified as a long-term asset.Remember, current assetswill be used up or converted to cash within 1 year. If the cost of an assetneedsto be spreadover more than 1 year, it is consideredlong term. The actual purchase of the assetis recorded as an asset exchange,not as an expense. Do not wolry about depreciation expense and interest expenseright now. That will be consideredwhen it is time to preparethe financial statements.Here is how the purchaseof the $4,000 computer with $1,000 down and a note payable of $3.000 with an annual interest rate of l2Vo, dte in 3 months. affects the accounting equation:

Assets

Liabilities

Shareholder's equity + Retained Contributed capital earnings

(1,000) cash + 4,000computer

* 3,000 notes payable

The recognition of the expenserelated to the cost of the computer will be deferredput off-until Tom's Wear has used the assetand is ready to preparefrnancial statements. The cash portion of the payment for the computer will be shown as an investing cash flow on the statementof cash flows. Transaction 2: Cash disbursementto settle a liability Last month, Tom hired a company to do some advertising for his business.On February 28,2006, Tom's Wear had not paid the full amount. Becausethe work was done in February,the expense was shown on the income statementfor the month of February. In March, Tom's Wear pays cashof $50 to settle-eliminate-the liability. Here is how the cash disbursementaffects the accounting equation:

Assets

Liabilities

Shareholder's equity

Contributed capital (50) cash

(50) other payables

Retained earnings

The action took place during February, so the expensewas shown on that month's income statement.The cash is now paid in March, but no expenseis recognized in

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116

lN T AND DEFERRA L S :I M I N G 1 5E V E R Y T H I N G A C C O U N T I N G CHAPTER . ACCRUALS 3

March becausethat would be double counting the expense.An expenseis recognized only once. The cash payment is an operating cash flow for the statementof cashflows. Transaction3: Collection of cash to settle a receivableAt the end of last month, Tom's Wear had not receivedall the cashit was owed by customers.Becausethe saleswere made during February,the revenuefrom those saleswas shown on the income statement for the month of February.Becausethe cash for the saleswas not collected at the time the saleswere made, Tom's Wear recorded accountsreceivable.Accounts receivableis an assetthat will be convertedto cash within the next year.When customers pay their bills, Tom's Wear records the receipt of cash and removes the receivable from its records. Here is how the collection of the cash affects the accounting equation:

Assets

Liabilities

equity Shareholder's Contributed + Retained capital earnings

* 150cash (150)accounts receivable

Revenueis not recorded when the cash is collected becausethe revenuewas already recordedat the time of the sale.To count it now would be double counting. The cash collection is an operating cashflow for the statementof cash flows. Transaction4: Paymentto vendor Atthe end of last month, the balancesheetfor Tom's Wear showedaccountspayableof $800. This is the amount still owed to vendorsfor Tom's Wear pays this debt, bringing the accountspayable balFebruary purchases. ance to zero. The cashpayment is an operating cash flow for the statementofcash flows.

Assets

Liabilities

equity Shareholder's Contributed + Retained capital earnings

(800)cash

(800)accounts payable

for 250 Tom'sWearpurchases shirtsat $4 each, of 5: Transaction Purchase inventory is The payscashfor thepurchase. cashpayment an operating a total of $1,000and of cashflow for the statement cashflows. Assets Liabilities

equity Shareholder's Contributed + Retained earnings capital

(1,000) cash + 1,000inventory

Transaction 6: Sales Tom's Wear sells 200 shirts at $10 each. all on account. That means the company extendedcredit to its customersand Tom's Wear will collect later.

Assets

Liabilities

equity Shareholder's Contributed + Retained capital earnings

-l 2,000 sales revenue

+ 2,000accounts receivable

At the sametime salesrevenueis recorded,Tom's Wear recordsthe reduction in inventory. The reduction in inventory is an expensecalled cost of goods sold.

CHAPTER . EFFECTO F A C C R U A L S N D D E F E R R A LO N F I N A N C I A L T A T E M E N T S 3 S A S S

117

Assets

Liabilities

Shareholder's equity Contributed capital * Retained earnings

(800)inventory

(800)costof goods sold

Notice that the saleis recordedat the amountTom's Wear will collect from the customer.At the sametime, the reduction in the inventory is recorded at the cost of the inventory-2}O shirts at a cost of $4 per shirt. This is a terrifrc example of the matching principle. Notice that there is no explicit recording of profit in the company records. Instead, profit is a derived amount; it is calculatedby subtractingcost of goods sold from the amount of sales.For this sale, the profit is $1,200. It is called the gross profit-also called gross margin-on sales.Other expensesmust be subtractedfrom the gross margin to get to net proht, also called net income. Up to this point, we have looked just at the routine transactionsduring the month ended March 3I, 2006. At the end of the month, Tom's Wear will adjust the company records for any accruals and deferrals needed for accurate financial statements.Look back over the transactionsand seeif you can identify the adjustmentsneeded.

Adjustments the Accounting to Records

A review of the transactionsfor March should reveal three adiustmentsneededat the end of March 2006: 1. Depreciation expensefor the computer 2. Insuranceexpensefor the month 3. Interest expenseon the note payable We will now look at eachof the adiustmentsand how the amountsfor those adiustmentsare calculated. Adjustment 1: Depreciation The computer purchasedon March 1 must be depreciated-that is, part of the cost must be recognized as depreciation expenseduring March. To figure out the depreciationexpense,the residual value is subtractedfrom the cost of the asset,and then the difference is divided by the estimateduseful life ofthe asset.In this case,the residual value is $400, so that amount is subtractedfrom the cost of $4,000.The remaining $3,600 is divided by 3 years,resulting in a depreciation expenseof $1,200 per year. Becausewe a"re preparing monthly statements, the annual amount must be divided by 12 months, giving $100 depreciation per month. The adjustmentis a reduction to assetsand an expense.

Assets

Liabilities

Shareholder's equity Retained Contributed *

capital earmngs

(100)
accumulated depreciation

(100)
depreciation expense

The reduction to the cost of the computer accumulateseach month, so that the carrying value of the assetin the accountingrecords goes down by $100 each month. In the accountingrecords, we do not simply subtract $100 each month from the computer's cost on the left side of the equation, becauseGAAP requires the cost of a specif,tcasset and the total accumulated depreciation related to that asset to be shown separately. The subtractedamount is called accumulated depreciation. After the first month, accumulated depreciation related to this particular asset is $100. After the second month, the accumulateddepreciationwill be $200. That amount-representing how

N oti ce, the resi dual ue is val deductedonl y i n the cal cul ati on the amou nt of of depreciationexpense. lt is not deductedfrom the cost of the assetin the company's formal records.

11 8

I T CHAPTER . ACCRUALS 3 AND DEFERRA L S :I M I N G 1 5E V E R Y T H I N GN A C C O U N T I N G

becauseit reducesthe much of the assetcost we count as used-is a contra-asset, recorded value of an asset. The cost of an assetminus its accumulated depreciation is called the book value or carrying value of the asset.Each time depreciation expenseis recorded, the accumulated depreciationincreases,and the book value ofthe assetdecreases. Depreciation expenserepresentsa single period's expenseand is shown on the income statement. Adjustment 2: Insurance expenseIn mid-February, Tom's Wear purchased3 months' worth of insurancefor $150, which is $50 per month. On the March 1 balancesheet, there is a current assetcalled prepaid insurancein the amount of $125. A full month of insuranceexpenseneedsto be recordedfor the month of March. That amount will be deductedfrom prepaid insurance.

Assets

Liabilities

Shareholder's equity

Contributed capital (50)prepaid insurance

Retained earnings
(50) insurance expense

Adjustment Notice that the calculation note for $3,000.The note carries an interestrate of l2%o.(Interestratesare typically of the interest expense given as an annualrate.) Becausethe firm is preparing a monthly income statement, doesnot take into The interestrate formula-Interest : it needsto accrue 1 month of interestexpense. consideration lengthof the Principal x Rate x Time-produces the following interest computation: the note.Theinterest expense would be the same = x out Interest $3,000 0.12x l/12 (l month of 12): $30 if thiswerea 6-month note or a Z-year note,or a note equity Liabilities Shareholder's Assets of anyotherlengthof time. Contributed + Retained Interest expense is capital earnings calculated based the on passed a time that has as (30)interest * 30 interest fraction a yearbecause of payable expense the interest rateusedisan annual rate. These are the neededadjustmentsat March 3I,2006, for Tom's Wear to produce accurate financial statementsaccording to GAAP. Exhibit 3.12 shows all of the transactionsand adjustmentsin the accounting equation worksheet.Notice how each financial statementis derived from the transactions.

On 3: Accruing interestexpense March 1, Tom's Wear signeda 3-month

Statements the Preparing Financial

are First, Tom's Wear preparesthe income statement.Revenuesand expenses found in the red-boxedcolumns of the accountingequationworksheet.Organizedard summarized,they produce the income statementfor Tom's Wear for March, shown in Exhibit 3.13. The income statementcoversa period of time-in this case,it covers I month of businessactivity. Second, Tom's Wear prepares the statement of changes in shareholder'sequity-a summaryof what hashappenedto equity during the period. It is shown in Exhibit 3.l4.L1ke the income statement,the statementof changesin shareholder'sequity covers a period of time-here, 1 month. liThird, Tom's Wear preparesthe balancesheet-composed of three sections:assets, abilities, and shareholder'sequity, with the amount of each on the last day of the period. The assetsare arrangedin order of liquidity-how easily the assetcan be convertedto cash. Current assets will be used or convertedto cashsometimeduring the next fiscal year.Longterm assetswill last longer than 1 year. Current liabilities are obligations that will be satisfiedin the next fiscal year.Long-term liabilities are obligations that will not be repaid in the next fiscal year. Becapitalandretainedearnings. equity is shownin two parts----contributed Shareholder's causethe balancesheetis a summary of all the transactionsin the accountingequation,it should balanceif there are no errorsin your worksheet.The balancesheetis shownin Exhibit 3.15.

A CHAPTER . EFFECTO F A C C R U A L S N D D E F E R R A LO N F I N A N C I A L T A T E M E N T S 3 S S S

119

EXHIBIT3.13 Tom's Wear, Inc. Income Statement For the Month Ended March 31, 2006

Income Statement for Tom's Wear for March

Salesrevenue Expenses Costofg oo dsso ld . . Depreciation expense Insurance expense Interest expense N etin co me

.. . .. . $ 2.000 ........... $

800 i00 50 30
...

t0m'swGf,l
980
$1,020

"'*'-'tt EXH|B|T 3.14 Tom's Wear, Inc. Statement of Changesin Shareholder's Equity For the Month Ended March 31, 2006

Statement Changes of in Shareholder's Equity for Tom's Wear for March

Beginning commonstock . Common stock issuedduringthe month . En dingc om m ons to c k .

Beginning retained earnings Net income for the month Dividends declared Ending retained earnings Total shareholder's equity

$ 5,000 0 ........ $5,000

$ r,220 1,020 0

E X HI B |T . 1 5 3
Tom's Wear, Inc. Balance Sheet At March 31. 2006
Liabilities and Shareholder's equity Cunent assets Cash $ 3,995 Accounts."""lrruUt" ..... 2,000 Inventory 300 Pre pa idin su ran c e . . . . . . . ID Total current assets 6,370 Computer (net of $100 accumu-lateddepreciation) 3,900 Total assets Current liabilities Interestpayable .............$ 30 Notes payable 3,000 Total current Iiabilities . . 3,030 Shareholder's equity Common stock 5,000 Retained earnings Total shareholder's equity Total liabilities and shareholder'sequlty . .$10,270

Balance Sheetfor Tom's Wearat March31,2005

$10,270

Fourth, Tom's Wear preparesthe statementof cashflows. Becausethe first three financial statements-income statement,statementof changesin shareholder'sequity, and the balance sheet-are accrual basedinsteadof cashbased,thesethree financial statements do not provide detailed information about a company's cash-where it came from and how it

12 O

lN T AND DEFERRA L S :I M I N G l S E V E R Y T H I N G A C C O U N T I N G CHAPTER . ACCRUALS 3

E XH |B|T .16 3
Statement of Cash Flows for Tom's Wear for March Tom's Wear, Inc. Statement of Cash Flows For the Month Ended March 31, 2006

l0m'swGal

Cash from operating activities: Cash collected from customers . . . . Cash paid to vendors Cash paid for operating expense Net cash from operating activities Cash from investing activities: Purchase ofasset* Cash from financing activities: Net increase (decrease) in cash Beginning cash balance Ending cash balance

150 (1,800) (50) $ (1,700) (1,000) 0 $ (2,700) 6,695 $ 3,995

$(1,000)

xComputer purchased $4,000. note signed $3,000 cash was paid $1,000. and was for A for was was spent. The balance sheet gives only the total amount of cash on hand at the close of businesson the last day of the fiscal period, and the income statement-the focus of financial reporting-gives no information about cash.This is why the statementof cash flows is of needed.Even though accrual accountingdoesnot basethe measurement income on cash, there is no debateabout the importance of the sourcesand usesof cash to a business.The statementof cashflows gives the details of how the cashbalancehas changedfrom the first day of the period to the last day. The statementis shown in Exhibit 3.16.

Statements on Accruals and Deferrals RealFirms'Financial

The most apparentplace on a set of financial statementsto identify accruals and deferrals is the balance sheet.Most often, the transactionshave been summarizedin such a way that the income statementdoesnot make accrualsand deferrals obvious. For example, if a firm shows salesrevenueon the income statement,the firm may or may not have collected the related cash.The place to find that information is the balance sheet. Take a close look at Circuit City's balance sheetsin Exhibit 3.17. Although there are many items on these statementsthat you are not familiar with, you should be able to see how much you have learned about financial statementsin three short chapters.For example, you know that it is a classified balancesheetbecausethere are subtotalsfor current assets and current liabilities. The assets are ordered by liquidity, with cash and cash equivalentsat the beginning of the assets.Notice that Circuit City starts its current liabilities section with merchandisepayable. This is what most companieswould call accounts you will f,rndthat each firm payable. As you look at more real firms' financial statements, you will be able to figure out what sort of acwill use some unique terminology. Usually, for count or amount it is. If you can not, take a look in the notes to the financial statements more information. Look down the balance sheet and see if you can identify specifi.caccruals and deferrals that the company probably recordedwhen it was preparing its year-endbalance sheet. Here are a few examples: This is listed as a current asset.It representsgoods or servicesthat l, Prepaid expenses. have been paid for but not used. Putting this amount on the balance sheetis deferring the expenseuntil the period in which the items are used.It is rare for the word expense to be on the balance sheet.Here it is the word prepaid that makes this an assetrather than an expenseon the income statement. 2. Accumulated depreciation. Ckcuit City has severaltypes of property and equipment. Notice that accumulated depreciation has been deductedfrom the recorded amounts for these assets,as indicated by the word net.In the firm's actual accounting records,

CHAPTER . EFFECTSF A C C R U A L S N D D E F E R R A Lo N F t N A N c t A LS T A T E M E N T S 3 o A S

121

HX8{EMET 3-17 Circuit City BalanceSheetsat February28,2006 and 2005

The three shadeditems arejust a few examples of accrualsand deferral that can easily be picked out from Circuit City's balance sheet

Circuit City Stores, Inc. Consolidated Balance Sheets

(Amounts thousands) in

At February 28 2006 2005

AsSets Current assets: Cash and cash equivalents s 315,970 $ 879,660 Short-term investments 52r,992 125,325 Accounts receivable, net of allowance for doubtful accounts . . . . . 220,869 230,605 Merchandise inventory 1,698,026 r,455,170 Deferred income taxes 29,598 31,194 The word I Income tax receivable 5,57r "expenses" is 41,315 23,203 Accumulated strange to see it Prepaid expenses and other current assets on the I depreciation Total current assets 2,933,341 2,745,I57 has already balance Property and equipment, net of accumulated depreciation 839,356 726,940 been sheet. It's Deferred income taxes only an asset 97,889 79,935 deducted Goodwill when 223,999 2L5,gg4 from the cost "prepaid" Other intangible assets,net of accumulated amortization 30,372 31,331 of the describes it Other assets 44,087 40,763 propefty and equipment Total assets $4,069,044 $3,840,010 (i.e.,net),bttt the amount will be Liabilities and stockholders' equity disclosedin the notes to the financial i I Here the $ 850,359 $ 635,674 statements. I word 202,300 170,629
"expenses" is preceded by "accrued." The expenses have been incurred but not yet paid for.

Short-term debt Current installments of long-term debt Total current liabilities Long-term debt, excluding current installments Accrued straight-line rent and deferred rent credits Accrued lease termination costs Otherliabilities .... Tota lliabilit ies . . . . . Commitments and contingent liabilities [Notes 12, 13, 14, and,l7l Stockholders' equity: Common stock, $0.50par value; 525,000,000 shares authorized; 174,789,390 shares issued and outstanding (188,150,383 2005) in Capital in excess ofpar value Retained earnings Accumulated other comprehensive income Total stockholders' equity Total liabilities and stockholders' equity

464,5tt 75,909 22,003

7,248

433,110 75,193 888

....1

r,622,330 r,3r5,494 51,995 19,944 256,r20 242,00r 79,091 90,734 104,885 9r,920

2,r14,4rr 1,760,093

87,395 94,075 458,2rr 72r,038 1,364,740 r,239,714 44,297 25,100 1,954,633 2,079,927 #4,069,044 $3,840,010

122

I T AND DEFERRA L S :I M I N G 1 5E V E R Y T H I N GN A C C O U N T I N G 3 CHAPTER . ACCRUALS

il] il-] 5il,,-' il: tif,",iFq r'dir.d'.#USineSS

Hollanls Jeffrey ness and WhyBig Business Listening, into social responsibility that "introducing der argues is an effective way of operations day-to-day business is The goal of a corporation to makemoneyfor its growth fi' andimproved long-term sustainable creating value. lt is. shareholder shareholders-that to increase performance." In Manyorganizations agree. nancial the statements report corporationS 2005, to isthejobof financial pounds of took 6.2 Apple Computer back million performance. social Where doesa corporations financial created business Delland HP haveactually e-waste. financral profitcenters between responsibility lsthere relationship fit in? a recycling. 2005,Dell In from computer performance a corporation's performance? social and pounds HPtook in 114million and took in 41 million "Corpoprize-winning report, Inthe2004Moskowitz pounds material recycling. for of A Meta-Analysis," Performance: rateSocial Financial and in As An organization called YouSowbegan 1992 positive relais researchers thatthere a significant found Responsibility ProSocial the and launched Corporate performance and corporate financial tionship between gramin 1997. s Read aboutit on the group Websiteat eviThe corporate socialperformance. study provides part www.asyousow.org.important of understandAn afcannot that corporations dence dispel notion to the responsibility. ing businessunderstanding is corporate responsible. fordto besocially Group Most:Howa Small ln hisbook,WhatMatters BigBusito Responsibility of Pioneers Teaching ls Social

Performance CorporateFinancial and CorporateSocialPerformance

representingthe amount of the assetsthe accumulateddepreciation is a contra-asset, company has recorded as depreciationexpenseover the life of the assets. As 3. Accrued expenses. part of the current liabilities (listed with accountspayable), acare crued expenses amountsthat the company has recognizedas expenses(i.e., put on the income statement).The company purchasedthese things on account. That is, the company still owes someonefor thesethings. It could be things suchasutilities payable or salariespayable-anything the company has used to generaterevenuebut has not yet paid for these goods or services.Again, there is the word expenseon the balance sheet. Here it is precededby the word accrued, which indicates that it is a liability rather than an expenseon the income statement. As you continue to learn about the underlying businesstransactionsthat are included in a you will seemore examplesof accrualsand deferrals that company's financial statements, are an integral part of GAAP. L.(}"5 C om put eand ex p l a i n wor k ing c apit ala n d th e q uic k r at io.
Working capitalequals currentassets minuscurrent liab ilities.

Ratio Analysis YourKnowledge: Applying

Capital Working
In Chapter 2, youlearned about the current ratio and how it provides information about the company's liquidity and ability to meet its short-term obligations. Working capital is another measureused to evaluateliquidity. Working capital is defined as current assetsminus current liabilities. The current ratio gives a relative measureof a company's ability to financeits operations,and the amount of working capital gives an absolutemeasure.Look at the information from the balancesheetof Circuit City in Exhibit 3 .ll . The working capital at February 28, 2006, was just over $ I .2 billion. Working capital : Current assets- Current liabilities

G C H A P TE R A P P LY INY OU RK N OW LE D GEA TIO N A LY S IS 123 3 o R: A Calculate the working capital at February 28,2005.If you subtract the current liabilities from the current assets, you should get$I,429,673,000, which is approximately $1.43 billion. Current assetshave increased for Circuit City during the year, between the two balancesheetdates,from$.2,745,157,000 $2,833,341,000. to During the sametime, current liabilities have increasedfrom $1,315,484,000 $I,622,330,000.This looks like a to significant decreasein working capital. Any company considering doing business with Circuit City might compute working capital for severalyears to identify any increasesor decreases. This decrease could indicatea decrease the company'sability to pay its curin rent liabilities.

QuickRatio
It is important that the information on the financial statementsbe accurate and reliable because is usedto help measurea company'sability to meet its short-termobligations. it As you learnedin Chapter2, the current ratio is current assets divided by current liabilities. Another ratio similar to the current ratio is called the quick ratio, also known as the acid-test ratio.Instead of using all of a company's current assetsin the numerator, the quick ratio uses only cash, short-term investments,and net accounts receivable. Thesethree assetsare the most liquid-easiest to convert to cash-so they are the most readily availablefor paying off current liabilities. You might seethe quick ratio defined as current assetsminus inventoriesdivided by current liabilities. An investor or analyst will use the quick ratio as a stricter test of a company's ability to meet its short-term obligations.It measures firm's ability to meet its short-termobligationsevenif the firm a makes no additional sales.

Quick Ratio : Cash + Accounts Receivable * Short-term Investments Current Liabilities

Use the information from Circuit City's balance sheet in Exhibit 3.17 to calculate both the current ratio that we studied in Chapter 2 andthe quick ratio. At its fiscal year end February 28,2005, Circuit City had current assetsof $2.745 billion and current liabilities of $ 1.315 billion. The currentratio is 2 .7 4 5 + 1 ,3 1 5 :2 .0 9 At February 28,2006, Circuit City had cunent assetsof $2.833 billion and current liabilities of $1.622billion. The currentratio is 2 .8 3 3 + 1 .6 2 2 :1 .75 The current ratio has declined, but it is still quite respectable. Calculate the quick ratio to see if we can get some additional insight. The numerator is the total of cash, shortterm investment,and accountsreceivable.At February 28,2005, the quick assetsare (rounded): 0.880 billion + 0.125 billion + 0.231billion : 1.236billion The denominator is unchanged,so the quick ratio at February 28,2005,is: 1.236billion + 1.315billion : 0.94 Similarly, the quick assetsat February 28,2006, are the total of cash, short-term investments, and accountsreceivable: 0.316 billion + 0.522 billion + 0.221billion : 1.059billion Again, the denominator is the sameas that used in the current ratio:

1.059 billion + I.622billion : 0.65

124

lN T AND DEFERRAL S :I M I N G l S E V E R Y T H I N G A C C O U N T I N G CHAPTER . ACCRUALS 3

It is very diffrcult to draw any conclusion from one or two ratios or one or two years.Would you find Circuit City's ratios more useful if you knew the industry averagesor the sameratios for Best Buy, one of Circuit City's major competitors?Calculate the current ratio and quick ratio for Best Buy when you take Your Turn 3-7.

Your Turn 3-7

Wmffi#,wffimg"gp

sheets calculate to from BestBuy'srecentbalance Usethe information 25,2006. the ratios Are the currentratio and the quickratioat February for City? in linewith the onescalculated Circuit
Best Buy Co., Inc. Balance Sheet(partial) Consolidated per shareamounts e $ i n m i l l i o n s , x c e pt

25,2006 February Assets Current equivalents Cash cash and i Short-termnvestments Receivables inventories Merchandise Othercurrent assets Totalcurrent assets I Totalcurrent iabilities [,.().6 Explain business the risks associated f inancial with records accounting and information. $ oat 3,051 506 3,338 409 7,98s 5,055

and Risk, Business Control, Ethics

In Chapters I and2, we discussedthe risks a businessfaces,particularly those risks associated with financial information. Now that you have learnedhow many transactionsare reflected on the financial statements, we will look at the three most significant risks associated with this information: L. Errors in recording and updating the financial accounting records 2. Unauthorized accessto the financial accounting records 3. Loss ofthe data in the financial accounting records No matter how transactionsare recorded,the information systemneedsto addressthe risks to oferrors in recording the data,unauthorizedaccess the data,and potential loss ofthe data.

Records the and Errors Recording Updating Accounting in

Errors in recording transactionscan lead to inaccuraterecordsand reports.Theseenors can be costly, both for internal decision making and external reporting. The accuracyand comThe controls that can minpleteness the recording processare crucial for a firm's success. of imize the risk of these errors include: (1) input and processingcontrols, (2) reconciliation and control reports, and (3) documentationto provide supporting evidencefor the recorded transactions.These controls should be presentin both manual and computerized accounting information systems. . Input and processing controls. This control is designedto make sure that only authorized transactionsare put into the system.For example,when a salesclerk entersa sale at a cashregister,the clerk must put in an employee code before entering the data.Additional controls, such as departmentnumbers and item numbers,help make sure that clerks enter the correct information. The computer program that controls this part of the accounting systemmay also have limits on the dollar amountsthat can be entered. The design ofthe controls dependson the accountinginformation systemand the business,but all firms should have controls to ensurethe accuracyofthe input and processing of the data that are recorded.

C H A P T E3 . C H A P T E R U M M A R YP O I N T S R S

125

. Reconciliationand control reports.This control is designedto catch any enors in the input and processingof the accounting data. Computerized accounting systemsare valuable becausethey make surethe accounting equation is in balanceat every stageofthe data entry. This type of equality with each entry is a control programmed into accounting software such as Peachtreeand QuickBooks. Accounting software does not guaranteethat all the transactionshavebeenrecordedcorrectly, but it doeskeep someerrors from occurring. . Documentation to provide supporting evidencefor the recorded transactions. This control is designedto keep errors from occurring and also to catch errors that have occurred. The employee who puts the data into the accounting system will get that data from a document that describesthe transaction.The information contained in the documentation can be comparedto the data put into the accounting system.For example, when a book-publishing company such as Prentice Hall sends an invoice to Amazon.com for a shipment of books, Prentice Hall will keep a copy of this invoice to input the datainto its accountingsystem.PrenticeHall may also usethis invoice to verify the accuracyof the accounting entry by referring back to the original invoice.

Unauthorized Access the Accounting to Information

Unauthorized access an obviousrisk for any company'saccountingsystem.Suchaccess is would exposea company to leaks of confidential data, errors, and the cover-up of theft. In manual systems,the records should be locked in a secureplace so that they cannot be accessedby unauthorizedemployees.Computerized systemshave user IDs and passwordsto control accessto the accounting system. There are serious ethical issuesrelated to a firm's data and computerized accounting systems. With the rapid expansionof the Internet and the developmentof wireless technologies, systems-related fraud has been on the rise. Firms must carefully screenall employees, but particularly those who are involved with developing and securing the firm's computer systems.No system is totally safe from fraud.

Lossor Destruction Accounting of Data

Imagine that you are working for severalhours on a report for your marketing class, and you saveyour work on your hard drive. You decide to step out for a coffee with friends before wrapping up. While you are gone, the computer shutsdown, and you cannot reboot. If you backedup your file, you are okay. Ifyou did not, you must startthe report from scratch. The accountinginformation systemcontains data that are crucial parts of a company's operations,so there must be a backup and disaster-recovery plan. The 2001 terrorist attack on the World Trade Center is perhapsthe most vivid example of why backup and disasterrecovery plans are important. Even before September 11, Fiduciary Trust International, a subsidiary of Franklin Templeton,used a method called remote shadowing, saving data simultaneously in two separatelocations. Having an offsite facility with a copy of the data, createdat the time of the transactions,enabled the company to conduct wire transfersfor cash and securitieson the date after the attacks.On Monday, September17, Fiduciary was ready to resume its core business.Although the loss of accounting data is insignificant in comparisonto the human loss suffered in this tragic event, it did bring the issue of lost and destroyeddata to the attention of companiesthat were affected that day.

Chapter Summary Points

Accountantswant the income statementto reflect the revenuesand expenses the period for coveredby the statement-none from the period before or the period after.Accountantsalso want the balancesheetto show the correct amount of assetsand liabilities on the date of the statement.To do that, accountantsmust allocate revenuesand expenses the correct perito ods. This is done by making adjustmentsat the end of the accounting period. . Sometimes a company purchasessomething and pays for it later. Sometimes a company earnsrevenuebut collects the cash for that revenuelater.

126

I T AND DEFERRA L S :I M I N G I S E V E R Y T H I N GN A C C O U N T I N G CHAPTER . ACCRUALS 3

. Accountantsdo not basethe recognition of revenuesand expenses the income stateon ment on the collection of cash or on the disbursementof cash. Revenueand expenses are recognized-shown on the income statement-when the economic substanceof the transactionhas taken place. The economic substanceof a transactionis the action of providing or receiving goods and services. . When the action has been completed but the dollars have not yet changedhands, it is called an accrual. Action comes first, and payment for that action comes later. You accrue-build up or accumulate-revenue you have earned or expensesyou have incurred, even though the cash has not been exchanged. . In some situations,the payment comeshrst and the action for that payment comeslater. Sometimesyou pay in advancefor goodsor services;or sometimesyour customerspay you in advancefor those goods or servicesyou will provide in a later period. Thesesituations are called deferrals. Dollars are exchanged,but you defer recognition of the revenueor expenseuntil the action of the transactionis complete.

Problems Summary Chapter

BB&B Decorating provides decorating servicesfor a fee. SupposeBB&B Decorating began the month of January 2007 with the following accountbalances:

Cash Supplies Equipment*

depreciation Accumulated Mi s c e l l a n e o upayabl es s Sa l a ri e p a y a bl e s

$ 200,000 20,000 100,000

(10,000) $ + O,OOO

Total assets $310,000

notespayable Long-term
Commonstock e R e ta i n e d a rn i ngs

4,000 50,000
126,000

Total l i abi l i ti es equi ty &

90,000

$310,000

,E q u i p me n t s depreci ated $10,000 by eachyear;w hi ch i s $833per month. i The following transactionsoccurred during January2007. additionalsuppliesfor $12,000on account(recordthe liability as miscellal. Purchased neouspayables) at 2. Paid salaries owed to employees December31,2006 for 3. Provideddecoratingservices $84,000cash payables(including purchase item 1) in 4. Paid entire balancein miscellaneous payables) 5. Purchased $15,000worth of supplieson account(recordas miscellaneous 6. Paid 6 months' worth of rent on buildings for $6,000, starting on January |, 2007 7. Made a paymenton the long-termloan of $5,000,of which $4,950was principal and $50 was interest for January Additional informatton: 1. There was $5,000 worth of supplies left on hand at the end of the month. 2. The equipment is being depreciatedat $833 per month. 3. At month-end, the following expensesfor January (to be paid in February) had not beenrecorded: utilities S 350 salaries $4,600

Instructions
Then, record 1. Setup an accountingequationworksheetand enterthe beginningbalances. eachtransactionincluding the neededadjustments.(Add any accountsyou need.) For 2. Preparethe four basic financial statements. the statementof changesin shareholdonly the retained earningspotlion of the statement. ers' equity, prepa.re

C H A P T E3 . C H A P T E R U M M A R Y P R O B L E M S R S

127

Solution
Assets = Liabil'ties + Shareholders Equi6/ Contributed Retained Eanutgs (RE) Capital

Supplies

Prepajd Rent

Equipment

Accumulated Depreciation, Miscellaneous Equipment Payables

Sal8ies Payables

Interest LT Notes Payables Payable

Comon Stock

| I I Revenues Expenses

| I I

Dividends

In(:ome Statemenl

Statement of Chdges in Shdeholder's Equity

* Balmce Sheet

Statement of C6h Flows

BB&BDecorating IncomeStatement For the Month EndedJanuary3L,2007

BB&B Decorating Statement Retained of Earnings For the Month EndedJanuary3I,2007

Revenue Expenses Net Income

$ 84,000 48,833 $ 3 5,167

Retained Earnings: Beginning balance

$ 90,000

BB&B Decorating Statement CashFlows of For the Month EndedJanuary3I,2007

BB&B Decorating Balance Sheet At January31,2007

Cash from operating activities Cash from customers Cash paid for operating expenses Cash paid for interest Net cash from operating actMties Cash from investing activities Cash from financing activities Cash paid on loan principal Net increase in cash Add beginning cash balance Cash balance at January 3l

$ 84,000 (62,000) (50) $ 21,950 (4,950) 17,000 200,000 $ 2 1 7,000,

Assets C ash .
Supplies Total current assets Equipment (net of $1 accumulated n) Total & Shareholder's Equity Miscellaneous payables Salaries payable Total current liabilities Long-term notes payable Shareholder's Equity Common stock Retained earnings Total liabilities and shareholder's equity

......

$217, 000 5,000 5,000 227,000 89,167 $316,167 15,350 4,600 19,950 45,050
I

di? i *,1,,! $ 3 1 6 ,1 6 7

128

I T AND DEFERRAL S :I M I N G I S E V E R Y T H I N GN A C C O U N T I N G CHAPTER . ACCRUALS 3

for 3 KeyTerms Chapter

Accrual(p. 99) depreciation Accumulated (p.111) Bookvalue(p.II2) Carrying value(p. 112) (p. Contra-asset 111)
Deferral (p.99) Depreciation expense (p.111) Interestpayable(p. 100) Prepaidrent (p. 108) Realized(p. 102) Residual value(p. 111) Timing differences (p. 99) Unearnedrevenue

(p.10s)
Working capital (p. I22)

TURN to Answers YOUR Questions

3 CHAPTER Your Turn 3-I x L. Youwouldpay$1,000 0.07x I/2 : $35in interest. via of 2. Thisis anaccrual-the actionof incurringtheexpense thepassage timeprecedes thecashpayment. Your Turn 3-2 The for needs be accrued. expense Junewouldroutinelybe recorded to expense Yes,salary To on is on July 15 whenthepayment made. gettheJunesalaryexpense theincomestateto the A needs accrue expense. monthof mentfor theyearendingJune30,ABC Company payable theamount in of as and for salaryexpense Juneis recorded salaryexpense salaries $56,000. Your Turn 3-3 at 31. 7 have been delivered December Thatmeans of Outof 12months magazines,months 31. has been earned December When by collected advance actually in 7ll2 of the$300,000 of was the thecash collected, recognition therevenue deferred-put off or postponedwas worth recognizes At 31, earned. December thecompany $175,000 because hadnotbeen it and on worthof revenue theincomestatement Thatmeans will put $ 175,000 it of revenue. revenue thebalance on sheet. reduce liability unearned the Your Turn 3-4 a recorded on madethe rent payment March 1, the company WhenAdvantage Company prepaidrenf.Now,it is 10 monthslater,and in cashandan increase the asset decrease in used. Thatmeans should recorded rentexpense. it be as ofrent hasbeen 10months'worth per month.Now, 10 I payment was $3,600for 1 year,which means The March $300 to mustbe deducted from prepaid rentandadded rent months $300permonth: $3,000 at on statement. of rentpaidon March1 will be shown theincome expense. Then,$3,000 Your Turn 3-5 an with $500 worth of suppliesand then purchased additional$650 1.. Konny started available thecompany use for to worth,whichmadea totalof $I , 150worthof supplies remainduringthemonth.At theendof themonth,therewere$250worthof supplies musthave used Of that ing.Thatmeans thecompany $900worth($1,150 $250). the as supplies. sheet a currentasset, remaining, supplies $250will be on thebalance for of 2. Supplies expense $900will be shownon the incomestatement April. Your Turn 3-6 value,$6,500- $500 : amountis the costminusthe residual(salvage) The depreciable per expense yearis $6,000/ life The estimated is 5 years.Thus,the depreciation $6,000. was on per the 5 : $1,200 year.Because computer purchased July 1,2006,only half a year

C H A P TE R MU LTIP LE -C H OIC E S TION S 129 3 . QU E of depreciationexpense,$600, will be shown on the income statementfor the year ending December3I,2006. The book value : cost less accumulateddepreciation(all the depreciation that has been recorded on the asset during its life) : $6,500 - $600 (for 2006) - $1,200(for 2007): $4,700at December31.,2007. Your Turn 3-7 The currentratio is $7,985+ $6,056 : I.32. The quick ratio is ($6At + $3,051 + $506) + $6,056 : 0.70. Theseratios are a bit lower than the onesfor Circuit City, but they appearto be reasonable. Questions 1. How does accrual basis accounting differ from cashbasis accounting? 2. What is deferred revenue? 3. What is accruedrevenue? 4. What are deferred expenses? 5. What are accruedexpenses? 6. What is interest and how is it computed? 7. Explain the difference between liabilities and expenses. 8. Name two common deferred expenses. 9. What does it mean to recognize revenue? 10. How does matching relate to accrualsand deferrals? 11. What is depreciation? 12. Why is depreciationnecessary? 13. What is working capital and what does it indicate? 14. What is the quick ratio and what does it measure? 15. What risks are associatedwith the financial accountins records?

Multiple-Choice Questions
1. Which of the following accountsis a liability? a. Depreciationexpense b. Dividends c. Accumulated depreciation d. Unearned advertisins fees , Which of the following is an example of an accrual? a. Revenuecollected in advance b. Suppliespurchased cashbut not yet used for c. Interest expenseincurred but not yet paid d. Paymentfor insurancepolicy to be used in the next 2 years 3. Which of the following is an example of a deferral? a. Cash has not changedhands and serviceshave not been rendered. b. Serviceshave been renderedbut nothing has been recorded. c. A business neverhas enoughcash. d. Resourceshave been purchasedfor cashbut not yet used. 4. The carrying (book) value of an assetis a. An account with a credit balancethat offsets an assetaccount on the balance sheet b. The original cost of an assetminus the accumulateddepreciation c. The original cost of an asset d. Equivalent to accumulateddepreciation Receiving a payment for a credit sale made in a previous accounting period will a. Decrease assets and decrease shareholders'equity b. Increaseassetsand increasesliabilities c. Have no net effect on total assets d. Increaserevenuesand increaseassets

13O

lN T AND DEFERRAL S :I M I N G l S E V E R Y T H I N G A C C O U N T I N G CHAPTER . ACCRUALS 3

6. When a company pays cashin Juneto a vendor for goodspurchasedin May, the transaction will inventory a. Increasecash and decrease cash b. Decreaseaccountspayable and decrease cash c. Decreaseaccountsreceivableand decrease d. Increaseaccountspayable and increaseinventory 7. Z Company's accountantforgot to make an adjustmentat the end of the year to record depreciationexpenseon the equipment.What effect did this omission have on the company's financial statements? a. Understatedassetsand liabilities assets and shareholders'equity b. Overstated c. Understatedliabilities and overstatedshareholders'equity d. Overstatedassetsand understatedshareholders'equity balanceof $1,000on January1, 2008. 8. Phillip's CameraStorehad a retainedearnings were $6,500.The companydeclared For year 2008, saleswere $10,500and expenses and distributed cashdividendsof $2,500on December31, 2008.What was the amount ofretained earningson December31,2008? a. $4,000 b . $ 1 ,5 0 0 c. $2,500

d. $1,s00
will be necessary: has beenused,the following adjustment 9. When prepaidinsurance decrease cash. insurance expense, a. Increase prepaidinsurance, decrease insurance expense. b. Increase increase prepaidinsurance. insurance expense, c. Increase prepaidinsurance. decrease insurance expense, d. Increase 10. The quick ratio is a. Current liabilities divided by the sum of cash, accountsreceivable,and shortterm investments b. Current assetsdivided by current liabilities divided by currentassets c. Accountsreceivable d. The sum of cash. accountsreceivable,and short-term investmentsdivided by current liabilities

ShortExercises
on SE3-1.Analyzeffict of transactions net income.(LO l) occurredduring a recentaccountingperiod. For each,tell whether The following transactions net net it (1) increases income,(2) decreases income,or (3) doesnot affectnet income. for cash a. Issuedstock b. Borrowed money from bank c. Provided servicesto customerson credit d. Paid rent in advance e. Used someof the supplies f. Paid salariesto employeesfor work done this year SE3-2. Calculatenet incomeand retainedearnings.(LO 1) Capboy Company earned $5,000 of revenuesand incurred $2,950 worth of expensesdurWhat ing the period. Capboy also declared and paid dividends of $500 to its shareholders. period? Assuming this is the first year of operations for Capboy, was net income for the what is the ending balancein retained earningsfor the period? (LO l, 2) SE3-3.Accountfor interestexpense. UMC Company purchasedequipment on November 1, 2008, and gave a 3-month, 97o nore with a face value of $10,000.How much interest expensewill be recognizedon the income statementfor the year endedDecember31, 2008?What effect does this adjustmenthave on the statementof cash flows for 2008? Is this adiustmentan accrual or deferral?

C H A P TE R S H OR T X E R C I 5 E S 3 . E (LO 1,3) SE3-4.Accountfor suppliesexpense. MBI Corporation starledthe month with $600 worth of supplieson hand. During the month, the companypurchasedan additional $760 worth of supplies.At the end of the month, $390 worth of supplieswas left on hand. What amount would MBI Corporation show as supplies expenseon its income statementfor the month? Is this adjustmentan accrual or deferral? (LO 1, 3) SE3-5.Accountfor insuranceexpense. Bovina Company was starledon Januaryl, 2005. During its first week of business, comthe pany paid $3,600 for 18 months' worth of fue insurancewith an effective date of January 1. When Bovina Companyprepares income statement the year endedDecember31,2005, its for how much prepaidinsurance will be shownon the balancesheet,and how much insuranceexpensewill be shown on the income statement? this adjustmentan accrualor deferral? Is (LO 1, 3) SE3-6.Accountfor depreciationexpense. Suppose companypurchases pieceofequipmentfor $9,000at the beginningofthe year. a a The equipment is estimatedto have a useful life of 3 years and no residual value. Using the depreciationmethod you learnedabout in this chapter,what is the depreciationexpensefor the first year of the asset'slife? What is the book value of the equipment at the end of the first year?What is the book value of the equipment at the end of the secondyear? (LO 1,3) SE3-7.Accountfor insuranceexpense. The correct amountof prepaidinsuranceshown on a company'sDecember3t,2007 , balance premium of $400. sheetwas $800. On July 1, 2008,the companypaid an additionalinsurance On the December 31,2008, balance sheet,the amount of prepaid insurancewas correctly shown as $500. What amount of insuranceexpensewould appearon the company'sincome statement the year endedDecember31, 2008?Is this adjustmentan accrualor deferral? for (LO 1, 3) SE3-8.Accountfor unearnedrevenue. Able Company received $4,800 from a customer on April I for servicesto be provided in the coming year in an equal amount for each of the 12 months beginning April. In the Able information system, these cash receipts are coded as unearnedrevenue.What adjustment will Able needto make when preparingthe December3l financial statements? What is the impact on the financial statements the necessary is not made?Is this adjustif adjustment ment an accrual or deferral? (LO 1,3) SE3-9.Accountfor suppliesexpense. Peter's Pizza started the month with $500 worth of supplies. During the month, Peter's Pizzapurchasedan additional $300 worth of supplies.At the end of the month, $175 worth of supplies remained unused. Give the amounts that would appear on the financial statements for the month for supplies expenseand supplies on hand. Is this adjustment an accrual or deferral? (LO 1,2,3) SE3-10.Identifyaccounts. From the following list of accounts:(1) Identify the assetsor liabilities that commonly require an adjustmentat the end of the accounting period, and (2) indicate whether it relates to a deferral or accrual. Cash Accounts receivable Prepaid insurance Supplies Building Accumulated depreciation-building Uneamed revenue Interest payable

131

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lN CHAPTER . ACCRUALS 3 AND DEFERRAL S :I M I N G 1 5E V E R Y T H I N G A C C O U N T I N G T

Salariespayable Common stock Retained earnings Salesrevenue Interest revenue Depreciation expense Insuranceexpense Supplies expense Utilities expense Rent expense (LO 1, 3) SE3-11.Accountfor unearnedrevenue. On January 1,2006, the law firm of Munns and Munns was formed. On February 1,2006, the companyreceived$18,000from clients in advancefor servicesto be performed monthly during the next 18 months. During the year, the firm incurred and paid expenses $5,000. of Is the adjustmentfor the service revenuean accrual or deferral?Assuming that these were the only transactionscompleted in2006, preparethe firm's income statement,statementof cash flows, statementof retained earningsfor the year endedDecember 3I,2006, and balancesheetat December31,2006. SE3-12. Calculatenet income.(LO 1, 4) Supposea company had the following accountsand balancesat year-end: Service revenue Interest revenue Unearnedrevenue Operating expenses Prepaid rent

$7,400 $2,200 $3,250 $1,500 $1,030

Preparethe income statementfor the year. SE3-13. Calculatenet income.(LO 1,4) Supposea company had the following accountsand balancesat year-end: Salesrevenue Interest revenue Rent expense Other operating expenses Dividends

$5,400 $1,200 $1,240 $3,050 $1,000

Calculate net income by preparing the income statementfor the year. SE3-14. Calculate working capital and quick ratio. (LO 5) Supposea firm had a current ratio of 1.5 at year-end,with current assetsof $300,000.How much working capital did the firm have?If current assets were madeup of $50,000accounts receivable, $100,000cash,and $150,000inventory,what was the quick ratio at year-end? SE3-15. Identify internal con*ols. (LO 6) the You have been hired to assess internal controls of Brown's Brick Company.The owner is concernedabout the reliability of the data from the frrm's accounting information system. What types of controls will you look for?

Exercises-Set A
(LO 1,2) E3-1A. Accountfor salariesexpense. Royal Company pays all salaried employeesbiweekly. Overtime pay, however, is paid in the next biweekly period. Royal accruessalary expenseonly at its December 31 year-end. Information about salariesearnedin December 2007 is as follows:

r CHAPTER3 EXERCISES

133

. . . .

Last payroll was paid on December26,2007 , for the 2-week period endedDecember26, 2001. Overtimepay earnedin the 2-week period endedDecember26,2007 was $5,000. Remainingworkdays in 2007 were December29, 30,31; no overtime was worked on thesedays. The regular biweekly salariestotal $90,000.

Using a 5-day workweek, what will Royal Company's balance sheet show as salaries payableon December31,2007? (LO 1, 3) E3-24. Accountfor unearnedrevenue. The TJ Company collects all service revenuein advance.The company showed a $12,500 liability on its December 31, 2006,balance sheet for unearned service revenue. During 2007, customerspaid $50,000 for future services,and the income statementfor the year ended December 3 l, 2007, reported service revenueof $52,700.What amount for the liability unearnedservice revenuewill appearon the balance sheetat December 31,2007? (LO 1,2) E3-3A. Accountfor interestexpense. purchased Sojourn Company equipmenton November 1,2006, and gave a 3-month,97o note with a face value of $20,000. On maturity, January 31, the note plus interest will be paid to the bank. Fill in the blanks in the following chart: Interestexpense (for the month ended) November30, 2006 Dec em ber 2 0 0 6 31, J anuar y 20 0 7 31, (LO 1, 3) E3-4A. Accountfor insuranceexpense. policy. It was recorded Baker Companypaid $3,600on July 1,2007,for a2-year insurance prepaid insurance.Use the accountingequation to show the adjustmentBaker will make as to properly report expenseswhen preparing the December 31,2007 financial statements. (LO 1, 3) E3-5A. Accountfor rent ex.pense. Susan rentedoffrce space her new business March 1, 2008.To receivea discount,she for on paid $3,600for 12 months'rent in advance. paymentappearon the How will this advance financial statementsprepared at year-end, December 31? Assume no additional rent was paid in 2009. Use the following chart for your answers: Rent expense the year for P repai d rent at D ecember 31 Cashoaid for interest

2008 2009
(LO 1, 3) E3-6A. Accountfor unearnedrevenue. In November and December 2009, Uncle's Company, a newly organized magazinepublisher, received$72,000for 1,0003-year(36-month)subscriptions a new monthly magazineat$24 to per year,startingwith the f,rrstissuein March 2010. Fill in the following chart for eachof the given yearsto show the amount of revenueto be recognizedon the income statementand the relatedliability reporledon the balancesheet. is Uncle's Company'sfiscal year-end December3 1. Revenue recognized during revenue D ecember at 31 U nearned

2009 201 0 2011 2012

(LO 1, 3) E3-7A. Accountfor insuranceexpense. Yodel & Companypaid $3,600 on June 1, 2008, for a2-year insurancepolicy beginning on that date. The company recorded the entire amount as prepaid insurance.By using the

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I CHAPTER . ACCRUALS T 3 AND DEFERRAL S :I M I N G I S E V E R Y T H I N GN A C C O U N T I N G

following chart, calculate how much expenseand prepaid insurance will be reported on The company'sfiscal year-endis December31. the year-endfinancial statements. Insurance expense P repai d nsurance D ece m ber i at 31

2008 2009 2010

(LO 1, 3) E3-8A. Accountfor depreciationexpense. a The ThomasToy Companypurchased new deliverytruck on January7,2006,for $25,000. truck is estimatedto last for 6 years and will then be sold, at which time it should be worth and has a fiscal yearapproximately$1,000.The companyusesstraight-linedepreciation end of December31. L. How much depreciation expensewill be shown on the income statementfor the year endedDecember3 1, 2008? 2. What is the book value (also called carrying value) of the truck on the balance sheet for each of the 6 years beginning with December 31,2006? E3-9A. Analyzetiming of revenuerecognition.(LO I, 2, 3) in Show eachof the following transactions the accountingequation.Then, tell whetheror not given is one that resultsin the recognition of revenueor expenses. the original transactionas for a. Dell Inc. paid its computerservicetechnicians $80,000in salaries the month endedJanuary31. building during b. Shell Oil used$5,000worth of electricityin its headquarters March. Shell receivedthe bill, but will not pay it until sometimein April. sales. Assumeall saleswere c. In2006, Chico's,FAS had $22 million in catalogue recordedas credit sales. income during 2006. d. Home Depot collected$59 million in interestand investment (LO 1, 3) E3-10A. Accountfor rent expense. year with $3,000of prepaidrent, $15,000of cash,and $18,000 BNP Companystartedthe of common stock. During the year, BNP paid additional rent in advance amounting to for $10,000.The rent expense the year was $12,000.What was the balancein prepaidrent on the year-end balancesheet? (LO 1, 3) E3-11A. Accountfor insuranceexpense. PrecoreCompany began the year with $6,500 prepaid insurance.During the year, Precore premiumsamountingto $8,000.The company'sinsurance prepaidadditionalinsurance expensefor the year was $10,000.What is the balancein prepaidinsurance year-end? at E3-I2A^. Accountfor rent expenseand preparefinancial statements.(LO 4) On March l, 2007, Quality Consulting Inc. was formed when the owners contributed in for $35,000cash in the business exchange common stock. On April l, 2007, the company paid $24,000 cash to rent office spacefor the coming year. The consulting services generated$62,000 of cashrevenueduring 2007. Preparean income statement,statementof changesin shareholders'equity, and statementof cash flows for the 10 months ended December 3I, 200'7 and a balance sheetat December 3I , 2001. , (LO 3, 4) and preparefinancial statements. E3-13A. Accountfor depreciationexpense in Southeast PestControl Inc. was startedwhen its ownersinvested$20,000in the business exchangefor common stock on January1,2006. The cashreceivedby the companywas immea diately usedto purchase $15,000heavy-dutychemicaltruck, which had no residualvalueand an expected useful life of 5 years.The companyeamed$13,000of cashrevenueduring 2006. statement changesin shareholders' of equity, and statement of Preparean income statement, cashflows for the year endedDecember31,2006, and a balancesheetat December3I,2006.

C H A P T E 3 . E X E R C I S E S 135 R

E3-14A. Classifi accounts.(LO 1, 4) Tell whether each of the following items would appearon the income statement,statement of changesin shareholders'equity, balance sheet,or statementof cash flows. Some items may appearon more than one statement. Interestreceivable Salary expense Notes receivable Unearnedrevenue Net cash flow from investing activities Insuranceexpense Retainedearnings Prepaid insurance Cash Accumulated depreciation Prepaid rent Accounts receivable Total shareholders'equity Accounts payable Common stock Dividends Total assets Net income Consulting revenue Depreciation expense Supplies expense Salariespayable Supplies Net cash flow from financing activities Land Net cash flow from operating activities

(LO 1,2,3) E3-15A.Analyzebusiness transactions. Analyze the following accountingequation worksheetfor StarwoodYacht Repair Corporation and explain the transactionor event that resulted in each entry.
NSEF

Liabilities Contributed Capita.l

Shileholder's

Equiw

Retained Emings

C6h

I I

Supplies

Prepaid Insurmce

Properry& Equipment (P&E)

Accumulated DepreciationP&E

Interest Payable

Sa.ldies Payable

Long-tem Notes Payable

Common Stock

_L tl ti
lt

Revenues

Expenses

rr5 00n 500

(376)' 1326)'

r375) 50u ( 1,00u) rl00)

(LO l, 2, 3, 4) E3-16A. P repare financial statements. Refer to E3-15A. Assume all beginning balancesare zero. Preparethe four financial statements for the period ended December 31, 2009 (balancesheetat December 31,2009). E3-17A. Computeworking capital and quick ratio. (LO 5) Use the given information to calculatethe amount of working capital and the quick ratio at December31. Balances from December31 balancesheet: Cash Accounts receivable Short-term investments Inventory Prepaid insurance Current liabilities

$5,460 2,500 1,000

? ?50

460 9,200

E3-18A. Identify internal controls. (LO 6) During Hurricane Katrina in 2005, Jamesand Dory law firm in New Orleans lost most of their financial records.What advice could you give the firm as they preparefor anotherhurricaneseason?

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CHAPTER . ACCRUALS I 3 AND DEFERRAL S :I M I N G 1 5E V E R Y T H I N GN . A C C O U N T I N G T

Exercises-Set B (LO I,2) E3-1B. Account.forsalariesexpense. Jack's Finance & Budget Consulting Inc. pays all salariedemployeesmonthly on the first Monday following the end of the month. Overtime, however,is recorded as comp time for all employees.Jack's allows employeesto exchangeall comp time not usedduring the year for pay on June 30 and pays it on July 15. Jack's accruessalary expenseonly at its June 30 year-end.Information about salariesearnedin June 2008 is as follows: . . . Last payroll was paid on June2,2008, for the month endedMay 31, 2008. Comp pay exchangedat year-endtotals $ I 50,000. The regularyearly salaries total $1,500,000.

Using a l2-month fiscal work year,what will Jack'sFinance& Budget ConsultingInc.'s payableon June30, 2008? balancesheetshow as salaries (LO 1, 3) E3-2ts,Accountfor unearnedrevenue. The Joe & Einstein Cable Company collects all service revenuein advance.Joe & Einstein showeda $16,825liability on its June30, 2008,balancesheet unearned for servicerevenue. During the following fiscal year, customerspaid $85,000 for future services,and the income statement the year endedJune 30,2009, reported servicerevenueof $75,850. for What amount for the liability unearnedservice revenuewill appearon the balance sheetat June30,2009? (LO 1,2) E3-38. Accountfor interestexpense. The Muzby Pet Grooming Company purchaseda computer on December 30, 2007, and gavea 4-month,TVo notewith a facevalue of $6,000.On maturity,April 30, 2008,the note plus interestwill be paid to the bank. Fill in the blanks in the following chart: Interestexpense Cashpaid for interest

january 31,2008 February 29,2008 March 2008 31, April30,2008

(LO 1, 3) E3-4B. Accountfor insuranceexpense. Inc. More & Blue PaintingProfessionals paid $6,300on Februaryl, 2008, for a 3-yearinsurancepolicy. In the More & BIue information system,this was recordedas prepaid insurance.Use the accounting equation to show the adjustmentMore & Blue will need to make to properly report expenses when preparing the June 30, 2008, financial statements. (LO 1, 3) E3-5B. Accountfor rent expense. Utopia Dance Clubs Inc. rentedan old warehouse its newestclub on October 1,2006. for To receivea discount,Utopia paid$2,970 for l8 months of rent in advance. How will this preparedat year-end,December3 1? advancepaymentappearon the financial statements Assume no additional rent is paid in 2001 and 2008. Use the following chart for your answers: for Rent expense the year P repai d rent at D ecember 1 3

2006 2007 2008

(LO 1, 3) E3-68. Accountfor unearnedrevenue. 2010, Lynn Haven Gazette,a newly organized newspaperpublisher, reIn May and June ceived $12,000 for 500 2-year (24-month) subscriptions to a new monthly community eventsnewspaperat $12 per year, starting with the frst issuein September2010. Fill in the following chart for each ofthe given years to show the amount ofrevenue to be recognized

C H A P TE R E X E R C IS E S 3 . on the income statementand the related liability reported on the balancesheet.Lynn Haven Gazette's fiscal year-endis June30. Revenue recognized revenueat June30 U nearned

2010 2011 2012

(LO 1, 3) E3-78. Accountfor insuranceexpense. All Natural Medicine Corporationpaid $2,178on August 1,2009, for an 18-monthinsurance policy beginning on that date.The companyrecordedthe entire amountas prepaidinsurance. By using the following chart, calculatehow much expenseand prepaid insurancewill be reported on the year-endfinancial statements. The company'syear-endis December31. lnsurance exoense at 31 Prepai d nsurance D ecember i

2009 2010 2011

(LO 1, 3) E3-88. Accountfor depreciationexpense. E. Hutson PastriesInc. purchased new delivery van on July 1, 2007, for $35,000.The a truck is estimatedto last for 5 years and will then be sold, at which time it should be worth nothing.The companyusesstraight-line depreciation and has a fiscal year-endofJune 30. a. How much depreciationexpensewill be shown on the income statementfor the year endedJune30, 2010? b. What is the book value (also called canying value) of the truck on the balance sheetfor eachofthe 5 yearsbeginningwith June30,2008? E3-9B. Analyzetiming of revenuerecognition.(LO 1,2,3) For each of the following transactions,tell whether or not the original transactionas shown is one that resultsin the recognitionofrevenue or expenses. a. On April 15, Mike's Pressure CleaningServicesInc. paid its employees $3,000 in salariesfor servicesprovided. b. Mister Hsieh Fencing Company used $ 1,000 worth of radio advertising during April. Mister received the bill but will not pay it until sometime in May. c. During 2007, Tootie'sPet Training SchoolInc. earned$125,000in service revenues.Assume all serviceswere offered on account. d. Susan's Investment Companycollected$130,000in interestand investment income earnedduring 2008. (LO 1,3) E3-10B. Accountfor rent expense. Florida's Number One Credit Solution Organization startedthe year with $1,850 of prepaid rent, $25,000of cash,and $26,850of retainedearnings. During the year,Florida paid adfor ditional rent in advance amountingto $16,275.The rent expense the year was $16,850. year-endbalance sheet? What was the balancein prepaid rent on the E3-118. Accountfor insuranc expens (LO 1, 3) e e. DurJ.B. Eriksen'sConstruction Companybeganthe yearwith $18,500prepaidinsurance. ing the year.J.B. Eriksen's prepaid premiumsamounting $96.000. to insurance additional The company'sinsurance for expense the year was $104,500.What is the balancein prepaid insuranceat year-end? E3-128. Accountfor rent expense and preparefinancial statements. and insuranceexpense (L O 3, 4) On February I, 2010, Breeder's Choice Pet Trainers Inc. was formed when the owners invested$25,626cashin the business exchange common stock. On March 1, 2010, the for in

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I CHAPTER . ACCRUALS AND DEFERRAL S :I M I N G l 5 E V E R Y T H I N GN A C C O U N T I N G T 3

company paid$22,212 cashto rent offlce spacefor the next 18 months and paid $3,414 cash The training servicesgenerated for 6 months of prepaidinsurance. $II5,125 of cashrevenue during the remainderof the fiscal year.The companyhas chosenJune30 as the end of its fisstatement changes shareholders'equity, stateof in and cal year.Preparean income statement, ment ofcash flows for the 5 monthsendedJune30, 2010, and abalancesheetat June30, 2010. (LO 3, 4) and preparefinancial statements. E3-138. Accountfor depreciationexpense TermiteSpecialists Inc. was started when its ownersinvested Northeast $32,685in the busifor nessin exchange common stock on July 1,2010. Part of the cashreceivedto startthe chemical sprayer, company was immediately used to purchasea $19,875 high-pressure which had a $2,875 residualvalue and an expecteduseful life of 10 years.The company during the yearandhad cashoperating expenses $21,205. of earned $68,315of cashrevenue Preparean income statement,statementof changesin shareholders'equity, and statement ofcash flows for the year endedJune30,2011, and a balancesheetat June30, 2011. E3-14B. Identfu accounts.(LO 1, 4) From the following list of accounts:(1) identify the assetsor liabilities that may require an adjustment at the end of the accounting period, and (2) indicate whether it relates to a deferral or accrual. Cash Accountsreceivable Prepaid insurance Prepaid rent Supplies Depreciation expense Insurance expense Suppliesexpense Utilities expense Rent expense Interest receivable Common stock Retainedearnings Salesrevenue Interest revenue Equipment Accumulateddepreciation-equipment Unearnedrevenue Interestpayable payable Salaries Accountspayable Other operatingexpense

E3-15B.Analyzebusiness transactions from the accountingequation.(LO L, 2, 3) Analyze the following transactionsfor Information ResourceServicesInc. and explain the transactionor event that resulted in each entry.
ASSets

Liabilitics Contributed Capital

Shdeholder's Equrty

RetaincdEmings

I
b

sh

I I

_ .. Prepaid AccounLs Renl ReceivaLle Suppljes

Property& Equipment (P&E) il2.5{J0

Accunrulated DepreciationP&E

Interesi Saldies Payable Payable

Long-tem Notcs Payable

Common Stock

Revenues ,-O**"1

112 500 u5.000

425 13 150

615)

(LO l, 2, 3, 4) E3-168. Prepare financial statemenrs. Refer to E3-158. Assume all beginning balances arezero. Preparethe four frnancial statementsfor the period endedJune 30,2007 (balancesheetat June30, 2007). E3-178. Computeworking capital and quick ratio. (LO 5) Use the given information to calculatethe amount of working capital and the quick ratio at December 31.

C H A P T E3 . P R O B L E M S R

139

Balances from December31 balancesheet: Cash Accounts receivable Short-term investments Inventory Prepaidrent Current liabilities

$2,s00 1,500 4,000

? ?50

150 9,000

Do you think the firm's quick ratio is high enough?Why or why not? E3-188. Identify internal controls. (LO 6) What are some controls that a company might use to make sureits financial statements contain accurateinformation?

Problems-Set A
(LO 1, 2,3,4) P3-1A. Recordadjustments prepare incomestatement. and Selectedamounts (at December 31,2001) from Soul Tan, Polish & Refine Inc.'s information system appearas follows: 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. Cashpaid employees salaries for and wages Cash collected from customersfor service rendered Long-term notes payable Cash Common stock Equipment Prepaid insurance Inventory Prepaid rent Retainedearnings Salaries and wagesexpense Servicerevenues

$ 300,000 1,850,000 500,000 150,000 60,000 840,000 30,000 250,000 140,000 130,000 328,000 2,000,000

Required
a. There are five adjustmentsthat need to be made before the financial statements can be preparedat year-end. in For each,show the adjustment the accounting equation. 1. The equipment(purchased January1,2007) has a useful life of 12 years on with no salvagevalue. (An equal amount of depreciationis taken each year.) 2. Interestaccruedon the notespayableis $1,000as of December31, 2007. 3. Unexpiredinsurance December31,2007, is $7,000. at 4. The rent paymentof $140,000coveredthe 4 monthsfrom December1, 2007,throughMarch 31, 2008. 5. Employeeshad earnedsalariesand wages of $28,000 that were unpaid at December31,2007. b. Preparean income statementfor the year ended December 31,2007 , for Soul Tan,Polish & Refine Inc. P3-24. Recordadjustments and calculatenet income.(LO 1, 2,3,4) The recordsof RCA Companyrevealedthe following recordedamountsat December31, 2006, before adjustments: Prepaid insurance Cleaning supplies Unearned service fees Notes payable Service fees Wagesexpense

$ 1,800 2,800 3,000 5,000 96,000 75,000

14O

I CHAPTER . ACCRUALS 3 AND DEFERRAL S :I M I N G 1 5E V E R Y T H I N GN A C C O U N T I N G T

Truck rent expense Truck fuel expense Insuranceexpense Suppliesexpense Interest expense Interest payable Wagespayable Prepaid rent-truck

3,900 1,100 0 0 0 0 0 0

Before RCA preparesthe financial statementsfor the business,adjustmentsmust be made for the following items: 1. 2. 3. 4. The prepaid insurancerepresentsan 1S-monthpolicy purchasedearly in January. A physical count on December 3 1 revealed$500 of cleaning supplieson hand. On December 1, a customerpaid for 3 months of service in advance. The truck rent is $300 per month in advance. January2001 rent was paid in late December 2006. 5. The bank loan was taken out October 1. The interest rate is I2Vo (l7o per month) for I year. for 6. On Wednesday, December31, the companyowed its employees working 3 days. The normal workweek is 5 days with wagesof $1,500paid at the end of the week. a. For each item, show the adjustmentin the accounting equation. b. Preparean income statementfor the year ended December31, 2006, for RCA Company. (LO 3) assers. P3-3A. Accountfor depreciable a Charlotte& Gary Motorcycle RepairCorporationpurchased machineon January1, 2008,for $8,000cash.Gary expectsto usethe machinefor 4 yearsand thinks it will be worthlessat the the end of the 4-yearperiod.The companywill depreciate machinein equal annualamounts.

Required

Required
a. Show the purchaseof the machine and the first year's depreciationin the accounting equation. b. Show how the machine will be presentedin the assetsection of the balance sheet at December3 1, 2008, and December3l , 2009, after appropriate adjustments. c. What amount of depreciationexpensewill be shown on the income statementfor the year endedDecember 3 1, 2008? What amount will be shown for the year endedDecember 31, 2009? d. Calculate the total depreciationexpensefor all 4 years of the asset'slife. What do you notice about the book value of the assetat the end of its useful life? (LO 1,2,3) P3-4A. Recordadjustments. The following is a partial list of financial statementitems from the records of Marshall's Companyat December31, 2008. Prepaid insurance Prepaidrent Interest receivable Salariespayable Unearnedfee income Interest income

$10,000 18,000 0 0 30,000 10,000

Additional information includes the following: policy indicatesthat on December31, 2008, only 5 monthsremain on 1. The insurance the 24-month policy that originally cost $18,000. 2. Marshall's has a note receivablewith $2.500 of interest due from a customeron January 1,2009.

C H A P T E3 . P R O B L E M S R

3. The accountingrecords show that one-third ofthe fees paid in advanceby a customer on July 1, 2008, has now been earned. 4. The companypaid $18,000for rent for 9 monthsstartingon August l, 2008. 5. At year-end,Marshall's owed $7,000 worth of salariesto employeesfor work done in December 2008. The next payday is January 5, 2009.

Required
a. Use the accounting equation to show the adjustmentsthat must be made prior to for the preparation of the financial statements the year endedDecember 31, 2008. b. Calculate the account balancesthat would be shown on Marshall's financial statementsfor the year ended December 31, 2008. (LO l, 2, 3) P3-5A. Recordadjustments. The following is a list of financial statementitems from Sugar & Spice Cookie Company as of December31,200'7 : Prepaid insurance Prepaid rent expense Wagesexpense Unearned subscriptionrevenue Interest expense Additional information:

$ 6,000 10,000 25,000 70,000 38,000

policyon July insurance business paida $7,200 premium a 3-year on 1,. The company t,2006. on 2,200'7andmustpay lIVo interest 2. Sugar Spice borrowed on & , $200,000 January yearof2007. 2,2008,for theentire January has revenue now been subscription 3. The books showthat $60,000of the unearned earned. 1,2007 . on paid 10months rentin advance November 4. Thecompany of on 3,2008. 31 for 5. Thecompany paywages $2,000 December to employees January of will Required that to a. Usethe accounting equation showtheadjustments mustbe madeprior to December 3l,2007 . for thepreparation thefinancialstatements theyearended of for on b. Calculate account balances wouldappear thefinancialstatements that the December theyearended 3I,2007. (LO P3-6A. Record adjustments. 1,2,3) balances theendof the year: at TheFruit Packing has Company thefollowing account
Prepaid insurance Unearnedrevenue Wagesexpense Taxespayable Interest income

$8,000 4,200 6,790 4,168 2,475

The company also has the following information available at the end of the year: 1. 2. 3. 4. Ofthe prepaidinsurance, $3,000has now expired. Ofthe unearned revenue, $2,000has beenearned. The companymust accruean additional$1,500of wagesexpense. The company has earnedan additional $500 of interest income, not yet received.

Required a. Use the accounting equation to show the adjustmentsindicated at year-end. b. Calculate the balancesin each account after the adjustments. c. Indicate whether each adiustmentis an accrual or deferral.

142

CHAPTER . ACCRUALS 3 AND DEFERRAL S :t M t N G t s E V E R y T H t N G N A c c o u N T t N G T r

P3-7A. Record adjustmentsand preparefinancial statements.(LO 1, 2, 3, 4) The accountingrecords for Sony SnowboardCompany,a snowboardrepair company,contained the following balancesas of December 31,2006: Assets Cash Accountsreceivable Land Totals $40,000 16,500 20,000 Li abi l i ti es and sharehol ders' it y equ Accountspayable C ommonstock R etai ned earni ngs

$76,soo

$17,000 45,000 14,500 $76,s00

The following accounting eventsapply to Sony's 2007 fiscal year: a. Jan. 1 The company acquired an additional $20,000 cash from the owners in exchangefor common stock. b. Jan. I Sony purchased computerthat cost $15,000for cash.The computer a had a no salvagevalue and a 3-year useful life. c. Mar. I The companyborrowed$10,000by issuinga l-year noteat 127o. d. May 1 The company paid $2,400 cash in advancefor a l-year leasefor office space. e. June 1 The company declaredand paid dividends to the owners of $4,000 cash. f. July I The companypurchased land that cost $17,000cash. g. Aug. I Cashpaymentson accounts payableamounted $6,000. to h. Aug. 1 Sony received$9,600cashin advance 12 monthsof serviceto be for performed monthly for the next year, beginning on receipt of payment. i. Sept. 1 Sony sold a parcelof land for $ 13,000cash,the amountthe company originally paid for it. j. Oct. I Sony purchased $795 of supplieson account. k. Nov. I Sony purchased short-terminvestments $18,000.The investments for pay a fixed nte of 6Vo. l. Dec. 31 The companyearnedservicerevenueon accountduring the year that amountedto $40,000. m. Dec. 3l Cashcollectionsfrom accounts receivable amountedto $44,000. n. Dec. 31 The companyincurredother operatingexpenses accountduring the on year of $5,450. 1. Salaries that had beenearnedby the salesstaffbut not yet paid amountedto $2,300. 2. Suppliesworth $180 were on hand at the end of the period. Basedon the precedingtransactiondata,there are five additional adjustments(for a total of seven)that need to be made before the financial statementscan be prepared.

Required
a. Preparean accounting equation worksheet and record the accountbalancesas of December31,2006. b. Using the worksheet,record the transactionsthat occurred during 2007 and the necessary adjustments neededat year-end. c. Prepareall four financial statementsfor the year ended December 31,2007 (balancesheetat December31,200'7). P3-8A. Recordadjustments preparefinancial statements. (LO 1, 2,3, 4) and Transactionsfor Pops Company for 2007 were: 1. The owners startedthe businessas a corporation by contributing $30,000 cash in exchangefor common stock. 2. The companypurchased office equipmentfor $8,000cashand land for 915,000cash. 3. The company earneda total of $22,000 of revenueof which $ 16,000was collected in cash. 4. The company purchased$890 worth of suppliesfor cash. 5. The company paid $6,000 in cash for other operating expenses.

r
C H A P T E3 . P R O B L E M S R 143 .,',:'::r ,';i

6. At the end of the year, the company owed employees$2,480 for work that the employeeshad done in 20O7.Thenext payday,however,is not until January4,2008. 7. Only $175 worlh of supplieswas left at the end of the year. The offrce equipment was purchased on January I and is expected to last for 8 years (straight-line depreciation,no salvagevalue). Required a. Use an accounting equation worksheet to record the transactionsthat occurred during 2007. b. Record any neededadjustmentsat year-end. c. Prepareall four financial statementsfor the year ended December 31,2007 (balancesheetat December3I,2007). (LO 1, 2,3,4) P3-9A. Recordadjustments preparefinancial statements. and On June 1, Joel Adams starteda computer businessas a corporation. Joel startedthe businessby contributing $25,000in exchangefor common stock.He paid 2 months of rent in advance totaling $500. On June 3, Joel purchasedsupplies for $600 and two computersat a total cost of $6,500.Joel expectsthe computersto last for 3 yearswith no residualvalue.Joel hired an office assistant,agreeingto pay the assistant$800 per month to be paid $400 on to June 15 and June 30. On June21, Joel paid $300 for a radio advertisement run immediately to announcethe opening of the business.Joel earned$4,200 in June, of which he collected $2,800in cash.At the end of the month, Joel had only $130 worth of supplieson hand.

Required
a. Use an accounting equation worksheetto record the transactionsthat occurred during the month of June and the adjustmentsthat must be made prior to the preparation of the financial statementsfor the month ended June 30. b. Preparethe four financial statementsfor Joel's company for the month ended June30 (balancesheetat June30). (LO 1, 2,3,4, 5) P3-10A. Recordadjustments preparefinancial statements. and The following is a list of accounts for and their balances CasaBella Interiorsat May 31 before adjustmentsand some additional data for the fiscal year ended May 31,2006. CasaBellaInteriors Accountsand balances 31-May-06 Casn Accountsreceivable Notesreceivable lnterestreceivable re P re p a i d n t Supplies Office equipment Accumulateddepreciation (officeequipment) Accountspayable p S a l a ri e s a y a b l e Interestpayable Unearnedservice revenue Long-termnotes payable Commonstock A d d i ti o n a lp a i d -i nc a p i ta l 2,600 8,400 5,000 2,300 1,7OO 400 23,400 ( 1,500) 500 $ +,SOO 9,300 1,000

CHAPTER o ACCRUALS 3 AND DEFERRAL S :I M I N G 1 5E V E R Y T H I N G A C C O U N T I N G T lN

R etai ned earni ngs Service revenue Salaryexpense Rent expense D epreci ati on expense Advertisingexpense Additional data: 1. 2. 3. 4. 5. 6.

5,000 19,800 4,650

4s0

Depreciation on the office equipment for the year is $500. Salariesowed to employeesat year-endbut not yet recorded or paid total 9750. Prepaid rent that has expired at year-endamounts to $800. Interestdue at year-endon the notesreceivable $120. is Interestowed at year-endon the notespayableis $840. Unearned service revenuethat has actually been earnedby year-endtotals $1,500.

Required
a. Make the adjustmentsneededat year-end.(Use the accounting equation.) b. Preparean income statementfor the year endedMay 3 1, 2006, and a balance sheet May 3I,2006. at P3-11A. Analyzebusiness (LO 1, 2,3,4) transactions and preparefinancial stqtements. The accounting departmentfor Setting Sun Vacation Rentalsrecordedthe following transactions for 2009, the first year ofbusiness. Setting Sun generates revenueby renting waterfront condominiums to vacationersto the area. When a reservation is made in advance, SettingSun collectshalf the week'srent to hold the reservation. However,SettingSun does not require reservations,and sometimescustomerswill come in to rent a unit the sameday. These types of transactionsrequire that Setting Sun's accounting departmentrecord some cashreceipts as unearnedrevenuesand others as earnedrevenues.

Required a. Explain the transactionor event that resulted in each entry in the accounting equation worksheet. b. Did Setting Sun Vacation Rentals generatenet income or net loss for the period endingDecember31,2009? How can you tell? c. Preparethe four financial statementsat year-end. Problems-Set B P3-18. Recordadjustments prepare incomestatement. (LO 1, 2,3,4) and Selectedamounts(at December31, 2008) from Budget Planning Company'saccounting records are shown here. No adiustmentshave been made.

Cash paid to employeesfor salariesand wages Cash collected from customersfor servicesrendered Long-term notes payable Cash Common stock Equipment Prepaidinsurance Inventory Prepaidrent Retainedearnings Salariesand wagesexpense Servicerevenue Required

30,000 780,000 140,000 175,000 120,000 330,000 428,000 3.000.000

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a'TherearefiveadjustmentsthatneedtobemadebeforethefinancialStatementS for the year endedDecember31, 2008, can be prepared.- - r- -r -'-- -" Show eachin an accountingequationworksheet. l. The equipment(purchased January1, 2008) has a useful life of 12 years on with no salvagevalue (equal amount of depreciationeach year). 2' I nt er es to n th e n o te s p a y a b 1 e n e e d S tobeaccruedfortheyeari ntheamount of $40,000. 3. Unexpiredinsurance December31,2008, is $40,000. at 4. The rent paymentof $120,000was madeon June 1. The rent paymentis for 12 months beginning on the date of payment. 5. Salariesof $58,000were earnedbut unpaid at December31, 2008. b. Preparean income statement the year endedDecember31, 2008, for Budget for PlanningCompany. P3-28. Recordadjustments and calculatenet income.(LO 1, 2,3,4) The recordsof JimenezElectric Companyshowedthe following amountsat December31, 200'7,before adjustments : Prepaidinsurance Supplies Unearnedservicefees Notespayable Servicefees Salaryexpense Prepaid rent Insurance expense Suppliesexpense Rentexpense Interestexpense Interest payable Wagespayable $ 1,500 3,500 4,000 30,000 106,000 65,000 3,900 0 0 Q 0 0 0

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Before Mr. Jimenezpreparesthe f,rnancialstatements his business,adjustmentsmust be for made for the following items: 1. The prepaid insurance is for a 12-month policy purchasedon March 1 for cash. The policy is effective from March l, 2001, to February 28, 2008. 2. A count of the supplies on December 31 revealed$400 worth still on hand. 3. One customerpaid for 4 months of service in advanceon December 1. By December 31, 1 month of the servicehad beenperformed. 4. The prepaid rent was for 10 months of rent for the company offtce building, beginning J unel. 5. The companytook out a bank loan on NovemberI,2001 . The interestrate is I27o (l7o per month) for 1 year. 6. As of December31, the companyowed its employees $5,000for work done in 2007. The next payday is in January2008.

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146

CHAPTER . ACCRUALS 3 AND DEFERRAL S :I M I N G I s E V E R Y T H I N GN A c c o U N T I N G T I

Required a. Show the adjustmentsin the accountlng equahon. b. Preparean income statementfor the year endedDecember 3I,2001 , for Jimenez Electric Company. (LO 3) P3-38. Accountfor depreciable assets. Super Clean Dry Cleaning purchaseda new piece of office equipment on January 1,2009, for $18,000 cash.The company expectsto use the equipment for 3 years and thinks it will 'i*";,:,i"'"EF;:;:" be worthless at the end of the 3-year period. The company depreciatesthe equipment in equal annual amounts.

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Required a. Show the adjustmentsin an accounting equation worksheetfor the first 2 years of depreciation. b. Prepare assetsectionofthe balancesheetat December31,2009, and the December 3I, 2010, after appropriateadjustments. c. What amount of depreciationexpensewill be shown on the income statementfor the year ended December 3 1, 2009?What amount will be shown for the year endedDecember 2010? 31, d. Calculate the total depreciationfor the life of the asset.What do you notice about the book value of the assetat the end of its useful life? (LO 1,2,3) P3-4B.Recordadjustments. The following is a partial list of financial statementitems from the recordsof StarnesCompany at December31,2006. Prepaidrent Prepaid insurance Service revenue Wagesexpense Unearnedservice revenue Interestexpense

$20,000 12,000 35,000 8,000 18,000 5,000

Additional information includes the following: policy indicatesthat on December31,2006, only 5 monthsremain on 1. The insurance the 12-monthpolicy that originally cost $12,000. 2. Starnes a notepayablewith $2,500of interest has that mustbe paid on January| ,2007. 3. The accountingrecords show that two-thirds of the servicerevenuepaid in advanceby a customeron March t has now beenearned. 4. On August l, the companypaid $20,000for rent for 10 monthsbeginningon August L 5. At year-end, StarnesCompany owed $500 worth of salariesto employees for work done in December. The next paydayis January3,2007.

Required
a. Use an accounting equation worksheetto record the adjustmentsthat must be made prior to the preparationof the financial statementsfor the year ended December31,2006. b. Calculatethe accountbalances that would be shownon Starnes'financial statements the year endedDecember 31,2006. for (LO l, 2, 3) P3-58. Recordadjustments. The following is a list of financial statementitems from Chunky Candy Company as of June 30. 2008. Chunkv's fiscal vear is from Julv 1 to June30. Prepaidinsurance Prepaidrent Wagesexpense Unearnedrevenue lnterest expense

$ 3,600 5,000 12,000 30,000 0

C H A P T E3 . P R O B L E M S R

147

Additional information : policy on January1, 2008. 1. The companypaid a $3,600premium on a 3-yearinsurance I,2001 ,withaninterestrateof llTo.Nointerest 2. Chunkyborrowed$100,000onJuly hasbeenpaid as ofJune 30,2008. 3. The books show that $10,000 of the unearnedrevenuehas now been earned. 4. The company paid 10 months of rent in advanceon March 1, 2008. on 5. Wagesfor June30 of $1,000will be paid to employees July 3'

Required
a. Use the accounting equation to record the adjustmentsthat must be made prior to for the preparationof the financial statements the fiscal year endedJune 30, 2008. b. Calculate the balancesthat would appearon the financial statementsfor the year endedJune30, 2008. (LO 1,2,3) P3-68. Recordadjustments. The Delphi Desk Company has the following amounts in its records at the end of the fiscal year: Prepaid insurance Unearnedrevenue Wagesexpense Accountspayable Interest revenue

$5,000 3,700 6;790 4,200

1 t ?5

The company also has the following information available at the end of the year: L. 2. 3. 4. Ofthe prepaidinsurance, $1,000has now expired. revenue, 1,700hasbeenearned. Of the unearned $ The companymust accruean additional$1,250of wagesexpense. A bill for $300 from the companythat providesthe desksthat Delphi Desk Company sells arrived on the last day of the year. Nothing related to this invoice has been recordedor paid. not 5. The companyhas earnedan additional$500 ofinterest revenue, yet received.

Required
a. Use an accounting equation worksheetto show the adjustmentsat the end of the year. b. Calculate the balancesin each account after the adjustments. c. Indicate whether each adjustmentis an accrual or deferral. (LO 1, 2,3,4) P3-78. Recordadjustments preparefinancial statements. and The accounting records for Beta Company containedthe following balancesas of Decemb e r 31. 2008: Assets Cash Accountsreceivable Prepaidrent Land Totals $SO,OOO 2 6 ,5 0 0 3,600 1 0 ,5 0 0 $90,600 E and S harehol ders' qui ty L i a b i li ti es Accountspayable $17,s00 Commonstock R e ta i ned earni ngs 48,600 24,500

$90.600

The following accounting eventsapply to Beta's 2009 fiscal year: a a. Jan. 1 Beta purchased computerthat cost $18,000for cash.The computer had a no salvagevalue and a 3-year useful life. b. Mar. 1 Thecompanyborrowed $20,000byissuinga2-yearnoteatl2%o. c. May 1 The company paid $6,000 cash in advancefor a 6-month lease starting on July I for offrce space. d. June I The company declaredand paid dividends of $2,000 to the owners.

14 4

CHAPTER . ACCRUALS 3 AND DEFERRA L S :T M I N Gt s E V E R y T H t N GN A c c o u N T t N G T t

e. July I f. Aug. I g. Aug. I h. Sept. 1 i. Oct. 1 j. Nov. 1

't.

Dec.31

l. Dec.31 m . Dec.31

The companypurchased land that cost $15,000cash. Cashpaymentson accounts payableamounted $5,500. to Beta received$13,200cashin advance 12 monthsof serviceto be for performed monthly for the next year, beginning on receipt of payment. Beta sold a parcel of land for $13,000,its original cost of the land. Beta purchased $1,300of supplieson account. Beta purchased short-terminvestments $10,000.The investments for earn a fixed rate of 57o per lear. The company earnedservice revenueon account during the year that amounted $50,000. to Cashcollectionsfrom accounts receivable amounted $46,000. to The companyincurredother operatingexpenses accountduring the on year that amounted $5,850. to

Additional information: 1. Salaries that had beenearnedby the salesstaffbut not yet paid amounted $2,300. to 2. Supplieson hand at the end of the period totaled$200. 3. The beginningbalanceof $3,600in prepaidrent was completelyusedup by the end of the year.

Required
a. Set up an accounting equation worksheet and record the accountbalancesas of D e c e mb er 31,2008. b. Record the transactionsthat occurred during 2009 and the necessaryadjustments at year-end. c. Prepareall four financial statementsfor the year ended December 31,2009 (balancesheetat December31, 2009).

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P3-8B. Recordadjustments preparefinancial statements. and (LO 1, 2,3, 4) Given the following transactionsfor Security Company for 2008: 1. The ownersstartedthe business a corporationby contributing$50,000cashin exas changefor common stock. 2. SecurityCompanypurchasedoffrceequipmentfor$5,000cashandlandfor$l5,000cash. 3. The companyearneda total of $32,000of revenueof which $20,000 was collected in cash. 4. The companypurchased $550 worth of suppliesfor cash. The company paid $6,000 in cash for other operating expenses. 6. At the end of the year, Security company owed employees$3,600 for work that the employees had done in 2008.The next payday, however,is not until January4,2009. Only $120 worth of supplieswas left at the end of the year. 8. The office equipment was purchasedon January 1 and is expectedto last for 5 years. There is no expectedsalvagevalue, and the company wants equal amountsof depreciation expenseeach year related to this equipment. Required a. Use an accounting equation worksheetto record the transactionsthat occurred during 2008. b. Record any adjustmentsneededat year-end. c. Prepareall four financial statements the year ended December 3 1, 2008 for (balancesheetat December31, 2008). P3-98. Recordadjustments preparefinancial statements. and (LO l, 2,3,4) On September1, Irene Shannonstarled ShannonCheckVerification Servrcesas a co{poration. Irene startedthe firm by contributing $37,000in exchangefor common stock.The new firm paid 4 months of rent in advance totaling $ 1,200and paid 10 months of insurancein advancetotaling $6,500.Both rent and insurancecoveragebeganon September1. On September 6, the firm purchasedsuppliesfor $800. The firm hired one employeeto help Irene and

CHAPTER3. PROBLEMS

149

agreedto pay the assistant$ I ,000 per month, paid on the last day of each month. Shannon to CheckVerification Servicespaid $200 for a newspaperadvertisement announcethe openof ing of the business. The firm earnedservicerevenueof $6,200in September, which $6,000 was in cash.At the end of the month, the firm had only $100 worth of supplieson hand.

Required
a. Using an accounting equation worksheet,record the transactionsthat occurred during the month of Septemberand the adjustmentsthat must be made prior to the preparationof the financial statementsfor the month ended September30. for b. Preparethe four financial statements ShannonCheck Verihcation Servicesfor (balance sheetat September30). the month ended September30 (LO I , 2, 3, 4) P3-108. Recordadjustments preparefinancial statements. and The company'saccounPuppy StudsInc. providesa stud servicefor seriousdog breeders. tant preparedthe following list of accountswith their unadjustedbalancesat the end of the fiscal year, March 3I, 2001. Cash Accountsreceivable P r epaid ur a n c e ins Prepaidrent S upplies E quipm ent A c c um ulat ed e p re c i a ti o n d Accountspayable revenue Unearnedservice Long-termnotes payable Commonstock A ddit ionalpai d -i nc a p i ta l Ret ained n i n g s ear Div idends revenue Service M is c ellaneou sp e ra ti n ge x p e n s e s o S alar y pens e ex Additional facts: 1. The company owes its employees$2,500 for work done in this fiscal year. The next payday is not until April. 2. $2,000 worth ofthe unearnedservice revenuehas actually been earnedat year-end. 3. The equipment is depreciatedat the rate of $ 1,700 per year. 4. At year-end$600 worth of prepaid rent and $15,000 of prepaid insuranceremains unexpired. 5. Intereston the long-termnote for a year at the rate of 6.57ois due on April l. to 6. Supplieson hand at the end of the year amounted $2,100. 7. On the last day of the fiscal year,the firm earned$20,000.The customerpaid $15,000 with cash and owed the remainder on account. However, the accountantleft early that day, so the day's revenuewas not recordedin the accounting records. Required a. Make the adjustmentsneededat year-end.(Use the accounting equation.) b. Preparean income statementfor the year endedMarch 3I, 2001, and a balance sheetat March 31,2001. (LO 1, 2,3, 4) P3-11B.Analyzebusiness transactions and preparefinancial statements. the following transacThe accounting department for SummerFestPromotions recorded tions for the fiscal year ended June 30, 2008. SummerFestPromotions generatesrevenue $ SZ,ZOO 47,500 2 0 ,000 1,800 1 0 ,350 1 3 7 ,500 (1 ,700) 3,500 3,000 35,000 50,500 9 1 ,450 8 7 ,120 5 ,320 226,850 1 4 9 ,450 7 5 ,000

15 0

CHAPTER . ACCRUALs 3 AND DEFERRA L S :T M T N Gs E V E R v T H t N GN A c c o u N T t N G T t t

by selling tickets for local eventssuch as concerts,frghts, and sporting events.Sometimes tickets are sold in advanceand sometimescustomerswill purchasetheir tickets the same day as the event. These types of transactionsrequire that the SummerFestaccounting department record some cashreceipts as unearnedrevenuesand others as earnedrevenues.

Accounts Receivable

Office Supplies

Prepaid Rent

Buitdings

Accmulated Depreciationp&E

Accounts Payable

Salilies Payable

Unemed Rent Revenue

Interest Payable

Long_tem Notes payable

Common Stock

Required
a. Explain the transactionor event that resulted in each item recordedon the worksheet. b. Did SummerFest Promotionsgenerate income or net loss for the fiscal year net endedJune30, 2008?How can you tell? c. Preparethe four financial statementsat year-end.

Financial Statement Analysis

F SA 3 -1 .(L O 2 ,3 ,4,5) Use the annualreport from Staples answerthesequestions: to a. Does Stapleshave any deferred expenses? what are they, and where are they shown? b. Does Stapleshave accruedexpenses? What are they, and where are they shown? c. what is the difference between a deferred expenseand an accruedexpense? d. Calculate the amount of working capital for the two most recent fiscal years. What information does this provide? F S A3 -2 .(L O2 ,3 ,4,s) Use Circuit City's balancesheetin Exhibit 3-ll onpage 121to answerthesequestions: a. The current assetsection showsprepaid expenses. What might thesepertain to? Have the "expenses" referredto herebeenrecognized(i.e., includedon the period'sincome statement)? b. The liabilities sectionshowsaccruedexpenses. What doesthis represent? Have the associated expenses beenrecognized? c. The liabilities section shows merchandisepayable. Explain what this is and what Circuit City will do to satisfy this liability. d. Calculate Circuit City's working capital at the balance sheetdatesgiven. What information does this orovide? F SA 3 -3 .(L O 2 ,3 ,4) Use CarnivalCorporation's balancesheetto answerthesequestions: a. Which current assetreflects deferred expenses? Explain what it meansto defer expenses, and give the adjustmentto the accounting equation that was probably made to record this asset.

TH P C H A P TE R C R ITIC A L IN K IN G R O B L E M S 3 . b. The liabilities section shows over $2 billion in customer depositsat November 30, 2005. Explain why this is a liability, and give the transaction(in the accounting equation) that resulted in this liability. Calculate the current ratio for Carnival Corporation for both years shown. Comment on your results.

151

Carnival Corporation Consolidated Balance Sheets

($ in millions, exceptpar value)

November30, 2005 2004

Assets Current Assets Cashandcashequivalents .... Short-term investments Accounts receivable, net Inventories Prepaid expenses and other Total current assets Property and Equipment, Net Goodwill Thademarks Other Assets Liabilities and Shareholder's Equity Current Liabilities Short-term borrowings Currentportion oflong-term debt . . Convertible debt subject to current put option Accountspayable Accrued liabilities and other Customer deposits Total current liabilities

..

$ 1,178 I 408 250 370

2,2r5 2t,3r2
3,206 I,282 4I7 $28,432

$ 643 T7 409 240 4r9 1,728 20,823

3,32I f ,306 458 $27,636

.. ..

$300 1,042 283 690 832 2,045 5,192

$381 681 600 631 868 1,873 5,034

Long-TermDebt
Other Long-Term Liabilities and Deferred Income Commitments and Contingencies (Notes 7 and 8) Shareholder's Equity Common stock of Carnival Corporation; $.01 par value; 1,960shares authorized; 639 shares a|2005 and 634 shares af2004issued . Ordinary shares of Carnival plc; $1.66par value; 226 shares authorized; 212 shares at2005 and 2004 issued . Additional paid-in capital Retained earnings Unearned stock compensation . Accumulated other comprehensive income Tleasury stock; 2 shares of Carnival Corporation at 2005 and 42 shares of Camival plc at 2005 and 2004, at cost Total shareholder's equity Total liabilities and shareholders' equity

5,727

6,29L

54r

353 7,38r r0,233 (13) 156 (1,144) 16,972 $28,432

353 7,311 8,623 (16) 54r (1,058) L5,760 $27,636

The wcompwying

notes are an integm|

part of these coreoLid,ated, Ji'nancial

statsmffits

Problems Critical Thinking

Risk and Controls
Is there anything in the annual report of Staples, given in the book's appendix, that addresses how the firm protects its accounting data?Be sureto use the entire annual report to answer this question.

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lN T AND DEFERRAL S :I M I N G l S E V E R Y T H I N G A C C O U N T I N G CHAPTER . ACCRUALS 3

Ethics
DVD-Online Inc. is in its secondyear of business.The company is totally Web based,offering DVD rental to online customersfor a fixed monthly fee. For $30 per month, a customer receivesthree DVDs each month, one at a time as the previous one is returned. No matter how many DVDs a customer uses (up to three), the fee is fixed at $30 per month. Customerssign a contract for a year, so DVD-Online recognizes$360 salesrevenueeach time a customer signs up for the service. The owner of DVD-Online, John Richards, has heard about GAAP, but he does not see any reason to follow these accounting principles. Although DVD-Online is not publicly traded, John does put the company's financial statements on the Web page for customersto see. a. Explain how DVD-Online would account for its revenueif it did follow GAAP. b. Explain to John Richards why he should use GAAP, and describe why his financial may now be misleading. statements c. Do you seethis as an ethicalissue?Explain. Group Prohlem Use the balance sheetfor Carnival Corporation shown in FSA 3-3. For each of the current assets and currentliabilities,preparea briefexplanationofthe natureofthe item. For each current liability, explain how you think the company will satisfy the liability.

Darden lnternetExercise:
Pleasego to the www.prenhall.com/reimersWeb site. Go to Chapter 3 and use the Internet Exercisecompanylink. Or try www.dardenrestaurants.com. IE3-1. If you were at a Darden property, what might you be doing? List two of the Darden chains. IE3-2. Click on Investor Relations followed by Annual Report and Financials and then select the HTML version of the most recent annual report. Find the Balance Sheetsunder FinancialReviewby clicking next or usingthe "contents"scroll bar.DoesDardenusea calendar year for its f,rscalyear? How can you tell? IE3-3. Refer to the assetsection. a. List the title of one assetaccount that includes accruedrevenue-amounts earned but not yet received in cash. b. List the title of one assetaccount that includes amountsthat have been paid for in cashbut havenot yet beenexpensed. c. List the title of one assetaccount that includes amounts that will be depreciated. d. For each account listed in a through c, identify the amount reported for the most recent year. Do these amounts still need adjusting?Explain why or why not. IE3-4. List the amountsreported for total current assetsand total current liabilities for the most recent year. Compute working capital. For Darden, what does the amount of working capitalindicate? total liabiliIE3-5. For the two most recent years list the amountsreported for total assets, ties, and total stockholders' equity. For each type of account, identify what the trend indicates.Does the accounting equation hold true both years? Pleasenote: Internet Web sites are constantly being updated.Therefore, if the information is not found where indicated, pleaseexplore the Web site further to find the information.