Chapter 4

CHAPTER 4
Income Measurement and

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

in the preparation and use of financial statements.
18*
20
Diff
2. Explain the differences between the cash and accrual

bases of accounting.
18*
20
Diff
3. Describe the revenue recognition principle and explain its

application in various situations.
1
18*
10
20
Easy
Diff
4. Describe the matching principle and the various methods

for recognizing expenses.
2
19*
20*
10
15
15
Mod
Mod
Mod
5. Identify the four major types of adjustments and determine

their effect on the accounting equation.
3
4
5
6
7
8
9
10
11
12
13
14
15
16
19*
20*
10
10
20
20
15
15
15
15
15
15
15
15
10
15
15
15
Easy
Easy
Easy
Easy
Easy
Easy
Easy
Mod
Easy
Easy
Easy
Easy
Mod
Mod
Mod
Mod
6. Explain the steps in the accounting cycle and the significance

of each step.
17
Easy
Learning Objective
*Exercise, problem, or case covers two or more learning objectives

Level = Difficulty levels: Easy; Moderate (Mod); Difficult (Diff)
4-1
4-2
FINANCIAL ACCOUNTING SOLUTIONS MANUAL
Estimated
Time in
Minutes
Level
8*
25
Mod
8*
9*
25
25
Mod
Diff
8*
9*
25
25
Mod
Diff

1
2
3
4
5
6
7
10*
20
20
20
15
20
25
15
60
Mod
Mod
Mod
Mod
Mod
Mod
Mod
Mod

of each step.
10*
90
Mod
Learning Objective
Problems
and
Alternates


# Original problem only
**Alternate problem only
CHAPTER 4 INCOME MEASUREMENT AND ACCRUAL ACCOUNTING
Learning Objective
Cases

Estimated
Time in
Minutes
Level
1*
30
Mod

1*
3*
5*
30
30
60
Mod
Mod
Diff

1*
2
3*
5*
30
30
30
60
Mod
Mod
Mod
Diff
3*
4
5*
6
30
25
60
45
Mod
Mod
Diff
Mod
5*
60
Diff


of each step.
4-3
4-4
QUESTIONS
1.
The accountant cannot show a stockholder or other user the companys assets,
such as cash and buildings. Instead, what the user sees is a representation or
depiction of the real thing. The accountant describes with words and numbers the
various items in the financial statements.
2.
Accountants strive to present financial statements that are both relevant to the
decisions made by users of the statements and also reliable or verifiable.
Sometimes, however, there are trade-offs. For example, in deciding whether an
asset that a company pledges as collateral for a loan is sufficient, a banker may
be most interested in the current value of the asset. That is, this amount may be
the most relevant attribute or characteristic of the asset for the bankers needs.
The accountant, however, may be reluctant to present the current value of the
asset on the balance sheet because of the difficulty in measuring the value of the
asset with any degree of reliability. The amount paid for the assetthat is, its
historical costmay be more reliable, although not as relevant to the bankers
decision.
3.
The realtor will recognize revenue from the sale of the home on July 8 if the cash
basis is used because this is the date cash is received. Revenue will be
recognized on June 12 if the accrual basis is used because this is the date the
sale takes place and thus is the date on which the revenue is earned.
4.
This statement is not entirely accurate. Because it is based on historical cash

flows, a statement of cash flows is not necessarily the most accurate source of
information on the future cash flow prospects for a company. An income
statement may in fact provide more important information about future cash flows.
For example, an income statement includes not only sales on a cash basis this
period but also sales on credit that will generate cash flows in future periods.
Similarly, a statement of cash flows reports only expenses that required a cash
outlay in the current period. An accrual-based income statement provides
information on accrued expenses that will result in a cash outlay in future periods.
5.
The time period assumption is important in accounting because financial

statement users want information about a company as of a particular point in time
and for distinct periods of time. For example, a potential stockholder wants to
know the financial position at the end of the most recent year and the profit of a
business for the most recent year. Under an accrual accounting system, revenues
are recognized when they are earned regardless of when cash is received, and
expenses are recognized when they are incurred regardless of when cash is
paid. The accountant does not wait until all of the cash from a sale has been
collected to report the sale on the income statement. In this way, the user of the
statement receives information on a timely basis.
4-5
6.
No, the recognition of revenue is not always the result of the acquisition of an
asset. Assume that a publisher sells a magazine subscription and collects cash
from the customer in advance. At the time cash is collected, the publisher incurs a
liability. As each months magazine is mailed to the customer, a portion of the
liability is satisfied and revenue is recognized. Thus, in some instances, revenue
results from the settlement of a liability.
7.
A company incurs a cost when it acquires an asset. For example, assume that a
retailer buys a product for $100 on October 21. On this date, it has incurred a
cost of $100 to acquire an asset, namely merchandise inventory. The asset will
be removed from the records and an expense recognized, namely cost of goods
sold, when the product is sold. In place of the inventory, the company will acquire
another asset, either cash or an account receivable. In summary, assets are
unexpired costs and expenses are expired costs.
8.
Depreciation is the process of allocating the cost of a tangible long-term asset to

its useful life. For example, the accountant attempts to recognize or match the
cost of a machine as an expense over the period of time that the machine is used
to manufacture products.
9.
The four basic types of adjustments are:

a. To recognize the expired portion of a prepaid expense. For example, an
adjustment is needed at the end of each month to recognize insurance
expense for the portion of an insurance policy that has expired during the
period.
b. To recognize the earned portion of a deferred revenue or liability. For
example, a publisher has to make an adjustment at the end of each period to
recognize the earned portion of a subscription.
c. To recognize expense at the end of the period before cash is paid. For
example, an adjustment is made at the end of the year to recognize income
tax expense, even though the taxes will not be paid until early in the following
year.
d. To recognize revenue at the end of the period before cash is received. For
example, a landlord will need to make an adjustment at the end of the month
for the rent owed by a tenant but not payable until some time during the
following month.
4-6
10.
Balance sheet accounts are called real accounts because they are permanent
and are not closed at the end of a period. Conversely, income statement accounts
are called nominal accounts because they are temporary and are closed at the
end of the period. For example, it would not make sense to close the Equipment
account at the end of the period. The account should stay on the books as long
as the company keeps the asset. On the other hand, Depreciation Expense on
the equipment is a temporary account that indicates the expense associated with
using the asset during the period and is therefore closed along with all other
income statement accounts at the end of the period.
11.
Closing entries serve two important purposes. First, the balances in all temporary
or nominal accounts are returned to zero to start the next accounting period.
Second, the net income and the dividends of the period are transferred to the
Retained Earnings account.
EXERCISES
LO 3
EXERCISE 4-1 REVENUE RECOGNITION
Cash collected at toll booth

Passes redeemed
Revenue recognized
$ 3,000,000
1,700,000
$ 4,700,000
Only the amount of passes that have been used should be recognized as revenue. The
difference between the $2,000,000 of passes issued and the $1,700,000 of passes
used is unearned revenue at this point.
LO 4
EXERCISE 4-2 THE MATCHING PRINCIPLE
1. b
2. c
3. b or c (would recognize immediately if supplies are normally used up within the
period)
4. c
5. a
6. c
7. a
8. c
9. b
EXERCISE 4-3 ACCRUALS AND DEFERRALS
LO 5
1.
2.
3.
4.
AL
DR
AA
DE
LO 5
4-7
5.
6.
7.
8.
DE
DR
AL
AA
EXERCISE 4-4 OFFICE SUPPLIES
To record office supplies used.

BALANCE SHEET
Assets
Liabilities
INCOME
STATEMENT
Stockholders Equity + Revenues Expenses
5/31 Office Supplies

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

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

2. To record prepayment of six months rent on September 1.
BALANCE SHEET
Assets
9/1 Prepaid
Rent
Cash
Liabilities
INCOME
STATEMENT
12,000
(12,000)
3. To record one month of rent expense on September 30.

BALANCE SHEET
Assets
9/30 Prepaid
Rent
Liabilities
INCOME
STATEMENT

Rent Expense
(2,000)
(2,000)
4. If the accountant forgot to record an adjustment on December 31, net income for
the year would be overstated by $6,000 ($2,000 per month 3 months).
4-8
LO 5
EXERCISE 4-6 DEPRECIATION
1. To record purchase of combine on July 1.

BALANCE SHEET
Assets
Liabilities
INCOME
STATEMENT
7/1 Equipment 100,000

Cash
(100,000)
2. Purchase price
Less: Estimated salvage value
Depreciable cost
$ 100,000
(16,000)
$ 84,000
3. Monthly depreciation = depreciable cost/estimated life = $84,000/84 months =

$1,000/month.
4. To record one months depreciation expense on July 31.
BALANCE SHEET
Assets
Liabilities
INCOME
7/31 Accumulated
Depreciation (1,000)
Depreciation
Expense
5. Equipment
Less: Accumulated depreciation (6 months
$1,000/month)
Carrying value
LO 5
STATEMENT

(1,000)
$ 100,000
(6,000)
$ 94,000
EXERCISE 4-7 PREPAID INSURANCEANNUAL

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

2. To record purchase of 24-month policy on April 1.
BALANCE SHEET
Assets
4/1 Prepaid
Insurance 72,000
Cash
(72,000)
Liabilities
INCOME
STATEMENT
4-9
EXERCISE 4-7 (Concluded)
3. To record expiration of nine months of insurance on December 31.

BALANCE SHEET
Assets
INCOME
Liabilities
STATEMENT
12/31 Prepaid
Insurance (27,000)
(27,000)
Insurance
Expense
4. Net income will be overstated by $27,000 if the accountant forgets to record an

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

BALANCE SHEET
Assets
Aug. Cash
=
27,000
Liabilities
Subscriptions
Received in
Advance
(900 30)
INCOME
STATEMENT
27,000
2. To record subscriptions earned during August and recorded on August 31.

BALANCE SHEET
Assets
8/31
Liabilities
INCOME
STATEMENT
Subscriptions
Received in
Advance
(7,500)
(40,500 + 27,000 60,000)
Revenue
Subscriptions
7,500
3. Net income for the month would be understated by $7,500 if the accountant forgot
to make the adjustment to recognize revenue earned.
4-10
EXERCISE 4-9 CUSTOMER DEPOSITS
LO 5
1. To record on April 1 receipt of customer deposit for three months of legal service.
BALANCE SHEET
Assets
4/1
Cash
=
9,000
INCOME
Liabilities
Customer
Deposits
STATEMENT
9,000
2. To record on April 30 one month of legal fees earned.

BALANCE SHEET
Assets
4/30
INCOME
Liabilities
Customer
Deposits
(9,000/3)
STATEMENT

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

BALANCE SHEET
Assets
10/27 Cash
INCOME
Liabilities
STATEMENT
(17,500)
Wages Expense (17,500)
3. To record accrual for two days wages on October 31.

BALANCE SHEET
Assets
10/31
INCOME
Liabilities
Wages Payable
(17,500/5 days
STATEMENT
7,000
2 days)
Wages Expense
(7,000)
4. To record payment of weekly payroll on November 3.

BALANCE SHEET
Assets
11/3 Cash
Liabilities
(17,500) Wages Payable
INCOME
+
(7,000)
STATEMENT

Wages Expense
(10,500)
4-11
5. Net income for October would be overstated by $7,000 if the company failed to
record accrued wages on October 31.
EXERCISE 4-11 INTEREST PAYABLE
LO 5
1. To record 12%, 90-day loan from First National Bank on March 1.
BALANCE SHEET
Assets
3/1 Cash
Liabilities
100,000 Note Payable
INCOME
STATEMENT
100,000
2. To accrue interest due on note for one month on March 31.

BALANCE SHEET
Assets
3/31
Liabilities
INCOME
STATEMENT
Interest Payable
1,000
(100,000 .12 30/360)
Interest Expense (1,000)
To accrue interest due on note for one month on April 30.

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

BALANCE SHEET
Assets
5/30 Cash
LO 5
(103,000)
Liabilities
Note Payable
Interest
Payable
INCOME
STATEMENT
(100,000)
Interest Expense
(1,000)
(2,000)
EXERCISE 4-12 PROPERTY TAXES PAYABLE

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

BALANCE SHEET
Assets
2007
12/31
Liabilities
Property Taxes
Payable
(50,000 1.05)
INCOME
52,500
STATEMENT

Property Tax
Expense
(52,500)
4-12
EXERCISE 4-12 (Concluded)
2. To record payment of 2007 property taxes on June 1.

BALANCE SHEET
Assets
2008
6/1 Cash
LO 5
1.
Liabilities
(52,500) Property Taxes

Payable
INCOME
(52,500)
EXERCISE 4-13 INTEREST RECEIVABLE
To record 10%, 60-day loan to MaxiDriver Inc. on June 1.

BALANCE SHEET
Assets
6/1
2.
Liabilities
INCOME
STATEMENT
Cash
(60,000)
Note
Receivable 60,000
To accrue interest due on note for one month on June 30.

BALANCE SHEET
Assets
Liabilities
INCOME
6/30 Interest
Receivable 500
(60,000 .10 30/360)
3.
STATEMENT
STATEMENT

Interest
Income
500
To record collection of note and interest at maturity date on July 31.

BALANCE SHEET
Assets
7/31 Cash
61,000
Note
Receivable (60,000)
Interest
Receivable
(500)
Liabilities
INCOME
STATEMENT

Interest Income
500
4-13
EXERCISE 4-14 UNBILLED ACCOUNTS RECEIVABLE
LO 5
1. Under the revenue recognition principle, revenue should be recorded when

services are performed, because this is the point at which revenue is earned.
2. To record on June 30 unbilled service fees earned during June.
BALANCE SHEET
Assets
6/30
Liabilities
Service Fees
Earned
LO 6
40,000
EXERCISE 4-15 THE EFFECT OF IGNORING ADJUSTMENTS

ON NET INCOME
1. O
2. U
3. O
1.
2.
3.
4.
5.
6.
STATEMENT
Accounts
Receivable 40,000
LO 5
LO 5
INCOME
4. O
5. O
6. U
EXERCISE 4-16 THE EFFECT OF ADJUSTMENTS ON THE
ACCOUNTING EQUATION
Assets
D
NE
D
NE
I
NE
Liabilities
NE
I
NE
D
NE
I
EXERCISE 4-17 THE ACCOUNTING CYCLE
Order in the accounting cycle: 4, 7, 1, 5, 3, 6, 2
Stockholders Equity
D
D
D
I
I
D
4-14
MULTI-CONCEPT EXERCISES
LO 1,2,3
EXERCISE 4-18 REVENUE RECOGNITION, CASH AND

ACCRUAL BASIS
1. Accrual-basis income statements:

HATHAWAY HEALTH CLUB
INCOME STATEMENTS
FOR THE YEARS ENDED DECEMBER 31
Sales*$
Expenses:
Depreciation**
Salaries and wages
Advertising
Rent and utilities
Total expenses
Net income (loss)
Year 1
122,000
Year 2
$152,000
Year 3
$ 182,000
$ 33,000
50,000
5,000
36,000
$124,000
$ (2,000)
$ 33,000
50,000
5,000
36,000
$124,000
$ 28,000
$ 33,000
50,000
5,000
36,000
$ 124,000
$ 58,000
*Year 1: $366,000/3 = $122,000 with a three-year membership; only one-third of

the total recognized.
Year 2: $122,000 + [(100)($900)/3] (additional three-year memberships sold in
second year, but only one-third recognized as revenue) = $152,000.
Year 3: $122,000 + $30,000 (additional year of revenue recognized on
memberships sold in year 2) + $30,000 (additional three-year memberships sold
in third year, but only one-third recognized as revenue) = $182,000.
**($100,000 $1,000)/3 years = $33,000 per year.
2. Under the revenue recognition principle, revenue is recognized not when cash is
received but rather when revenue is earned. It is earned with the passage of time
as members use the facilities over their respective three-year membership periods.
Accrual-basis income statements allow the reader to focus on the long-term
profitability of the business rather than simply on the amount of cash received in
any given year.
LO 4,5
4-15
EXERCISE 4-19 DEPRECIATION EXPENSE
1. Depreciation
Truck
Computer
Building
expense for 2007:

[($18,000 $3,000)/5] 9/12
[($55,000 $5,000)/10] 6/12
[($250,000 $10,000)/30] 3/12
=
=
=
$2,250
$2,500
$2,000
2. Certainly, it would be less costly in terms of the time spent by the accountant to
expense all costs rather than treat certain ones as assets to be written off over their
useful lives. However, this is a violation of the matching principle which requires
that costs be allocated to the periods during which they provide benefits, i.e., aid
the generation of revenue. Estimates such as those required to depreciate assets
are a normal and necessary part of an accrual accounting system.
LO 4,5
EXERCISE 4-20 ACCRUAL OF INTEREST ON A LOAN
1. To record two-month, 12% bank loan on July 1.

BALANCE SHEET
Assets
a. 7/1 Cash
Liabilities
50,000 Notes Payable
INCOME
STATEMENT
50,000
To accrue one-month interest on bank loan on July 31.

BALANCE SHEET
Assets
b. 7/31
Liabilities
INCOME
Interest Payable
500
(50,000 .12 1/12)
STATEMENT

Interest Expense
(500)
To record repayment of principal and interest on bank loan on August 31.

BALANCE SHEET
Assets
c. 8/31 Cash
2.
Liabilities
(51,000) Interest Payable

Notes Payable
INCOME
+
(500)
(50,000)
STATEMENT

Interest Expense
(500)
It would save the time and cost in making a journal entry to skip an adjustment on
July 31 and simply record interest when the loan is repaid on August 31. However,
to do so would violate the matching principle. One of the necessary costs in July
was interest, and it should be matched with the revenues of that period. If interest
were not accrued at the end of July, the expense for that month would be
understated and the expense for August would be overstated.
4-16
PROBLEMS
PROBLEM 4-1 ADJUSTMENTS
LO 5
1. Adjustments on March 31, 2007:

To accrue interest.
BALANCE SHEET
Assets
a. 3/31
Liabilities
INCOME
Interest Payable
100
(15,000 .08 30/360)
STATEMENT

Interest Expense
(100)
To record supplies used.

BALANCE SHEET
Assets
Liabilities
INCOME
b. 3/31 Office Supplies

on Hand
(660)
(1,280 + 750 1,370)
STATEMENT

Supplies Expense
(660)
To record depreciation.
BALANCE SHEET
Assets
c. 3/31
Liabilities
INCOME
Accumulated
Depreciation
Office
Equipment (800)
(62,600 5,000) 1/72
STATEMENT

Depreciation
Expense
(800)
To accrue wages.
BALANCE SHEET
Assets
d. 3/31
Liabilities
Wages Payable
(950 6)
INCOME
+
5,700
STATEMENT

Wages Expense
(5,700)
To recognize rent earned.

BALANCE SHEET
Assets
e. 3/31
Liabilities
Rent Collected
in Advance
INCOME
STATEMENT

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

BALANCE SHEET
Assets
f. 3/31
Liabilities
Customer
Deposits
(4,800/4)
INCOME
STATEMENT

Service Revenue
1,200
(1,200)
To record estimated income taxes.

BALANCE SHEET
Assets
g. 3/31
Liabilities
Income Tax
Payable
INCOME
STATEMENT

Income Tax
Expense
3,900
2. Income before adjustments

Rent revenue
Service revenue
Interest expense
Supplies expense
Depreciation expense
Wages expense
Income tax expense
Adjusted net income
LO 5
(3,900)
$ 23,000
+ 2,500
+ 1,200
(100)
(660)
(800)
(5,700)
(3,900)
$ 15,540
PROBLEM 4-2 ANNUAL ADJUSTMENTS
1. Adjustments on December 31, 2007:

To record annual depreciation expense.
BALANCE SHEET
Assets
a. 12/31
Liabilities
INCOME
STATEMENT
Accumulated
Depreciation (2,950)
(15,000 250)/5 years
Depreciation
Expense
(2,950)
To record supplies used during the year.

BALANCE SHEET
Assets
Liabilities
b. 12/31 Supplies
on Hand (19,350)
(3,600 + 17,600 1,850)
INCOME
STATEMENT

Supplies
Expense
(19,350)
4-17
4-18
To record customer deposits earned between August and December.

BALANCE SHEET
Assets
c. 12/31
Liabilities
INCOME
STATEMENT
Customer
Deposits
(20,000)
(24,000/6 months) 5 months
Fees Earned
20,000
To record rent expense for November through December.

BALANCE SHEET
Assets
Liabilities
INCOME
STATEMENT
d. 12/31 Prepaid Rent (5,400)

(2,700 2)
Rent Expense
(5,400)
To accrue interest payable on note.

BALANCE SHEET
Assets
e. 12/31
Liabilities
INCOME
STATEMENT
Interest Payable
3,000
(200,000 .09 60/360)
Interest Expense
(3,000)
To accrue wages payable at year-end.

BALANCE SHEET
Assets
f. 12/31
Liabilities
Wages Payable
INCOME
STATEMENT
500
2. Net increase (decrease) in net income from adjustments:

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

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

BASIS FOR ANNUAL ADJUSTMENTS
LO 5

To recognize expired insurance.
BALANCE SHEET
Assets
Liabilities
INCOME
STATEMENT
a. 12/31 Prepaid
Insurance (1,000)
(7,200 5/36)
Insurance
Expense
(1,000)
To recognize rent earned.

BALANCE SHEET
Assets
b. 12/31
Liabilities
INCOME
Rent Collected in
Advance
(6,000 7/12)
STATEMENT

Rent Revenue
3,500
(3,500)
To recognize interest earned.

BALANCE SHEET
Assets
Liabilities
c. 12/31 Interest
Receivable 1,500
(50,000 .09 4/12)
INCOME
STATEMENT

Interest Revenue
1,500
2. If adjustments were made at the end of each month, the Prepaid Insurance account
would have been reduced by the monthly expense of $200 ($7,200/36) on four
occasions: August 31, September 30, October 31, and November 30. Thus, the
balance in the account before the December adjustment would be $7,200 [(4)
($200)] = $6,400.
4-20
LO 5
PROBLEM 4-5 USE OF ACCOUNT BALANCES AS A BASIS

FOR ADJUSTMENTS
1. Adjustments on April 30, 2007:

To recognize one months insurance expense.
BALANCE SHEET
Assets
Liabilities
INCOME
a. Prepaid Insurance (50)
STATEMENT

Insurance Expense
(50)
To record supplies used.

BALANCE SHEET
Assets
b. Office Supplies
(250 180)
Liabilities
INCOME
(70)
STATEMENT

Office Supplies
Expense
(70)
BALANCE SHEET
Assets
Liabilities
INCOME
c. Accumulated
Depreciation
Office Equipment
(417)
(50,000 1/120)
STATEMENT

Depreciation
Expense
(417)
BALANCE SHEET
Assets
d. Accumulated
Depreciation
Automobile
(200)
(12,000 1/60)
Liabilities
INCOME
STATEMENT

Depreciation
Expense
(200)
4-21
To record commissions earned.

BALANCE SHEET
Assets
e.
Liabilities
Unearned
Commissions
(9,500 5,000)
INCOME
STATEMENT

Commissions
Earned
(4,500)
4,500
To record revenue earned, not yet collected.

BALANCE SHEET
Assets
f. Accounts
Receivable
Liabilities
INCOME
STATEMENT

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

BALANCE SHEET
Assets
g.
Liabilities
INCOME
Interest Payable
STATEMENT

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

BALANCE SHEET
Assets
h.
Liabilities
Salaries Payable
INCOME
STATEMENT
2,500

Insurance expense
Office supplies expense
Commissions earned
Commissions earned
Interest expense
Salaries expense
Net increase in net income
Salaries Expense
(2,500)
(50)
(70)
(417)
(200)
4,500
1,500
(20)
(2,500)
$ 2,743
3. The office equipment was purchased on April 1, 2006, and has been depreciated
for one year before depreciation is recorded for the month of April 2007. Thus, if
the equipment has a 10-year life, the balance in Accumulated Depreciation will be
$50,000/10 years, or $5,000.
4-22
LO 5
PROBLEM 4-6 RECONSTRUCTION OF ADJUSTMENTS FROM

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

BALANCE SHEET
Assets
Liabilities
INCOME
STATEMENT
6/30 Prepaid Insurance (150)

(3,600 3,450)
Insurance Expense
(150)
2. Cost of policy was $150 36 months = $5,400.

3. To record depreciation expense on June 30.
BALANCE SHEET
Assets
Liabilities
INCOME
STATEMENT
6/30 Accumulated
(Depreciation (80)
(1,360 1,280)
Depreciation
Expense
(80)
4. Estimated useful life in months: $9,600/$80 month = 120 months.

5. To record interest expense on June 30.
BALANCE SHEET
Assets
6/30
Liabilities
Interest Payable
(2,448 2,304)
INCOME
STATEMENT
144
Interest Expense
(144)
6. Interest rate: ($144 per month 12 months)/$9,600 = 18%.

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

BASIS FOR ADJUSTMENTS
1. Recording adjustments:
To record rent expense.
BALANCE SHEET
Assets
a. Prepaid Rent
=
(600)
Liabilities
INCOME
STATEMENT

Rent Expense
(600)
PROBLEM 4-7 (Continued)
To record expense of worn-out videos.

BALANCE SHEET
Assets
INCOME
Liabilities
STATEMENT
b. Video Inventory (2,460)
Video Expense
(2,460)
To record depreciation expense on display stands.

BALANCE SHEET
Assets
c. Accumulated
Depreciation
INCOME
Liabilities
STATEMENT

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

BALANCE SHEET
Assets
d.
INCOME
Liabilities
Wages and
Salaries
Payable
STATEMENT

Wages and
Salary
Expense
1,450
(1,450)
To record subscription revenue earned.

BALANCE SHEET
Assets
e.
INCOME
Liabilities
Customer
Subscriptions
STATEMENT
(2,440)
Subscription
Revenue
2,440
To record accrued income taxes.

BALANCE SHEET
Assets
f.
Liabilities
Income Taxes
Payable
Explanations:
(a) $7,200/12 months
(b) $25,600 $23,140
(c) ($8,900 $500)/60 months
INCOME
+
849
STATEMENT

Income Tax
Expense
(849)
4-23
4-24
(f) Calculation of taxes due:

Subscription revenue
Rental revenue
Wage and salary expense ($2,320 + $1,450)
Utility expense
Advertising expense
Rent expense
Video expense
Income before tax
tax rate
Income tax expense
$ 2,440
9,200
(3,770)
(1,240)
(600)
(600)
(2,460)
(140)
$ 2,830
0.30
$
849
2. On the basis of the information available, Four Star appears to be a profitable

business. Subscription revenue and rental revenue together total $11,640 for the
month. Net income for the month is $2,830 $849 (taxes), or $1,981. This results
in a profit margin of $1,981/$11,640, or 17%.
MULTI-CONCEPT PROBLEMS
LO 2,3,4
PROBLEM 4-8 CASH AND ACCRUAL INCOME

STATEMENTS FOR A MANUFACTURER
1. Cash revenue: 500,000 components $2

Less: Amounts not yet received
Cash revenue
Accrual revenue: 500,000 components $2
$ 1,000,000
150,000
$ 850,000
$ 1,000,000
2. Under the matching principle, Drysdale should match all expenses to revenues
generated. Thus, all expenses should be recognized during the year, except for the
cost of the truck. The cost of $10,000 should be spread over the estimated useful
life of five years.
4-25
3. Income statement under the accrual basis:

DRYSDALE COMPANY
INCOME STATEMENT
FOR THE YEAR ENDED XX/XX/XX
Sales revenue
Cost of goods sold
Gross profit
Operating expenses:
Sales and administrative salaries
Truck depreciation
Total operating expenses
Net income
$ 1,000,000
602,000*
$ 398,000
$
$
$
*Rent: $1,000 12
Raw materials
Salaries and wages
Cost of goods sold
$
$
100,000
2,000**
102,000
296,000
12,000
400,000
190,000
602,000
**$10,000/5 years
LO 3,4
PROBLEM 4-9 REVENUE AND EXPENSE

RECOGNITION
Income statements for Years 1 and 2:

DARBY DELIVERY SERVICE
INCOME STATEMENTS
Sales revenue (a)
Expenses:
Advertising (b)
Salaries (c)
Rent (d)
Total expenses
Net income
Year 1
$ 23,000
Year 2
$ 46,000
$ 2,000
15,000
5,000
$ 22,000
$ 1,000
$ 1,500
24,000
5,000
$ 30,500
$ 15,500
4-26
Explanations:
a. Let X = Year 1 sales
Year 1 sales + 2(Year 1 sales) = $69,000
3X = $69,000;
X = $23,000 = Year 1 sales
2X = $46,000 = Year 2 sales
b. Total advertising expense
$3,500
Less promotional portion
500
Total weekly expense
$3,000 or $1,500/year
Year 1 advertising = $500 + $1,500 = $2,000

Year 2 advertising = $1,500
c. Let X = one employee's annual salary
1st year = X + 0.25X
2nd year = 2X
X + 0.25X + 2X = $39,000
3.25X = $39,000; X = $12,000
1st year = $12,000 + 0.25($12,000) = $15,000
2nd year = 2($12,000) = $24,000
d. Same rent for two years: $10,000/2 = $5,000
LO 5,6
PROBLEM 4-10 MONTHLY TRANSACTIONS,

ADJUSTMENTS, AND FINANCIAL STATEMENTS
1. Effects on the accounting equation:

To record issuance of stock to owners on January 2.
BALANCE SHEET
Assets
1/2 Cash
60,000
(3 20,000)
Liabilities
INCOME
STATEMENT

Capital
Stock
60,000
To record purchase of a Victorian inn on January 2.

BALANCE SHEET
Assets
1/2 Land
House
Cash
Liabilities
INCOME
STATEMENT
15,000
35,000
(50,000)
To record issuance of two-year, 12% promissory note on January 3.

BALANCE SHEET
Assets
1/3 Cash
=
30,000
Liabilities
Notes Payable
INCOME
STATEMENT
30,000
To record purchase of furniture for cash on January 4.

BALANCE SHEET
Assets
1/4 Furniture
Cash
Liabilities
INCOME
STATEMENT
15,000
(15,000)
To record purchase of 24-month insurance policy on January 5.

BALANCE SHEET
Assets
1/5 Prepaid
Insurance
Cash
Liabilities
INCOME
STATEMENT
6,000
(6,000)
To record payment for advertising on January 6.

BALANCE SHEET
Assets
1/6 Cash
Liabilities
INCOME
(450)
STATEMENT

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

BALANCE SHEET
Assets
1/7 Cleaning
Supplies
Liabilities
Accounts Payable
950
INCOME
+
950
STATEMENT
4-27
4-28
To record payment of wages for first half of month on January 15.

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

BALANCE SHEET
Assets
1/16 Cash
Liabilities
980 Rent Received

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

BALANCE SHEET
Assets
1/31 Cash
Liabilities
INCOME
STATEMENT
8,300
Revenue from
Rental of Rooms 8,300
To record cash receipts from restaurant for January on January 31.

BALANCE SHEET
Assets
1/31 Cash
Liabilities
INCOME
STATEMENT
6,600
Restaurant
Revenue
6,600
To record payment of dividends for January on January 31.

BALANCE SHEET
Assets
1/31 Cash
(3 200)
=
(600)
Liabilities
INCOME
STATEMENT

Dividends
(600)
2. List of accounts and account balances:

Assets
Cash
Land
House
Furniture
Prepaid Insurance
Cleaning Supplies
$ 29,600
15,000
35,000
15,000
6,000
950
Liabilities
Accounts Payable
Notes Payable
Rent Received in Advance
Owners Equity
Capital Stock
Advertising Expense
Wages Expense
Revenue from Rental of Rooms
Restaurant Revenue
Dividends
950
30,000
980
$ 60,000
450
4,230
8,300
6,600
600
3. Adjustments:
To record depreciation expense on the house.
BALANCE SHEET
Assets
Liabilities
INCOME
STATEMENT
a. Accumulated
Depreciation
House
(100)
Depreciation
Expense
(100)
To record depreciation expense on the furniture.

BALANCE SHEET
Assets
Liabilities
INCOME
b. Accumulated
Depreciation
Furniture
(125)
STATEMENT

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

BALANCE SHEET
Assets
c.
Liabilities
Interest Payable
INCOME
+
300
STATEMENT

Interest Expense
(300)
4-29
4-30
To record expired insurance.

BALANCE SHEET
Assets
Liabilities
INCOME
STATEMENT
d. Prepaid Insurance (250)
Insurance Expense
(250)
To record earned portion of guests deposit.

BALANCE SHEET
Assets
e.
Liabilities
INCOME
STATEMENT
Rent Received
in Advance (490)
Revenue from
Rental of Rooms
490
To record wages earned by employees.

BALANCE SHEET
Assets
f.
Liabilities
Wages Payable
INCOME
+
5,120
STATEMENT

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

BALANCE SHEET
Assets
Liabilities
INCOME
g. Cleaning Supplies (720)
STATEMENT

Supplies Expense
(720)
To record utility expense.

BALANCE SHEET
Assets
h.
Liabilities
Utilities Payable
INCOME
+
740
STATEMENT

Utilities Expense
(740)
To record income tax expense.

BALANCE SHEET
Assets
i.
Liabilities
Income Tax
Payable
INCOME
+
1,007
STATEMENT

Income Tax
Expense
(1,007)
Explanations for adjusting entry amounts:

(a) ($35,000 $5,000)/300 months = $100/month
(b) $15,000/120 months = $125/month
(c) $30,000 12% 1/12 = $300/month
(d) $6,000/24 months = $250/month
(e) $980/2 weeks = $490/week
(f)
$5,120 for second half of month
(g) $950 $230 = $720 used

(h) $740 due at end of month
(i) Calculation of tax expense:
Revenue from rental of rooms
Restaurant revenue
Wages expense
Advertising expense
Depreciation on house
Depreciation on furniture
Interest expense
Insurance expense
Supplies expense
Utilities expense
Income before tax
Tax rate
Income tax expense
$ 8,790
6,600
(9,350)
(450)
(100)
(125)
(300)
(250)
(720)
(740)
$ 3,355
0.30
$ 1,007
4-31
4-32
4. Financial statements:
(a)
MOONLIGHT BAY INN

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

STATEMENT OF RETAINED EARNINGS
Beginning balance, January 1, 2007

Add: Net income
Deduct: Cash dividends
Ending balance, January 31, 2007
0
2,348
600
$ 1,748
4-33
(c)
MOONLIGHT BAY INN

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

a. To accrue interest: $10,000 4% 1/12.
BALANCE SHEET
Assets
Liabilities
INCOME
STATEMENT
6/30 Interest Receivable 33
Interest Revenue
33
b. To record supplies used: $475 + $5,600 $507.

BALANCE SHEET
Assets
Liabilities
INCOME
STATEMENT
6/30 Office Supplies

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

BALANCE SHEET
Assets
Liabilities
INCOME
6/30 Accumulated
Depreciation
Machinery (3,500)
STATEMENT

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

BALANCE SHEET
Assets
Liabilities
INCOME
6/30 Prepaid Rent (1,550)
STATEMENT

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

BALANCE SHEET
Assets
6/30
Liabilities
Wages Payable
INCOME
+
6,000
STATEMENT

Wages Expense
(6,000)
4-35
PROBLEM 4-1A (Concluded)
f.
To record estimated income taxes.

BALANCE SHEET
Assets
6/30
2.
Liabilities
Income Taxes
Payable
INCOME

Income Tax
Expense
2,900
Income before adjustments

Interest revenue
Supplies expense
Rent expense
Wages expense
Income tax expense
Adjusted net income
LO 5
STATEMENT
(2,900)
$ 35,000
33
(5,568)
(3,500)
(1,550)
(6,000)
(2,900)
$ 15,515
PROBLEM 4-2A ANNUAL ADJUSTMENTS
1. Adjustments:
a. To record annual depreciation expense: ($25,000 $4,000)/7 years.
BALANCE SHEET
Assets
12/31 Accumulated
Depreciation
Liabilities
INCOME
STATEMENT

Depreciation
Expense
(3,000)
(3,000)
b. To record supplies used during year: $1,200 + $12,900 $900.

BALANCE SHEET
Assets
12/31 Supplies
on Hand
Liabilities
INCOME
STATEMENT

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

months) 6 months.
BALANCE SHEET
Assets
12/31
Liabilities
Customer
Deposits
INCOME
STATEMENT

Fees Earned
(6,600)
6,600
4-36
d. To record rent expense for September through December: $4,000 4.

BALANCE SHEET
Assets
12/31 Prepaid Rent
INCOME
Liabilities
STATEMENT
(16,000)
Rent Expense
(16,000)
e. To accrue interest payable on note: $30,000 6% 60/360.

BALANCE SHEET
Assets
12/31
INCOME
Liabilities
Interest Payable
f.
300
Interest Expense
BALANCE SHEET
12/31
INCOME
Liabilities
Wages Payable
830
PROBLEM 4-3A RECURRING TRANSACTIONS AND

ADJUSTMENTS
1, 11, 12
5, 1
2, 1
4, 7
1, 3
1,18
16,1
5, 1,10
i.
j.
k.
l.
m.
STATEMENT

a. Depreciation expense
b. Supplies expense
c. Fees earned
d. Rent expense
e. Interest expense
f. Wage expense
Overstatement of 2007 net income
a.
b.
c.
d.
e.
f.
g.
h.
(300)
To accrue wages payable at year-end: $4,150/5.
Assets
LO 5
STATEMENT
2, 13
17, 6
19, 9
14, 4
15, 3
Wage Expense
(830)
(3,000)
(13,200)
6,600
(16,000)
(300)
(830)
$ (26,730)
LO 5
4-37
PROBLEM 4-4A USE OF ACCOUNT BALANCES AS A

BASIS FOR ANNUAL ADJUSTMENTS

a. To record supplies used: $5,790 $1,520.
BALANCE SHEET
Assets
12/31 Supplies
Liabilities
INCOME
STATEMENT
(4,270)
Supplies
Expense
(4,270)
b. To recognize revenue earned: $1,800 8/12.

BALANCE SHEET
Assets
12/31
Liabilities
Unearned
Revenue
INCOME
STATEMENT

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

BALANCE SHEET
Assets
12/31
Liabilities
Interest
Payable
INCOME
STATEMENT

Interest Expense
(2,000)
2,000
2. If adjustments were made at the end of each month, the Unearned Revenue
account would have been reduced by the monthly revenue of $150 ($1,800/12) at
the end of each of seven months, beginning on May 31 and ending on November
30. Thus, the balance in the account before the December adjustment would be
$1,800 [(7)($150)] = $750.
4-38
LO 5

1. Adjustments on June 30, 2007:

a. To recognize one month's rent expense.
BALANCE SHEET
Assets
Liabilities
INCOME
STATEMENT
6/30 Prepaid Rent (600)
Rent Expense
(600)
b. To record supplies used: $15,210 $1,290.

BALANCE SHEET
Assets
Liabilities
INCOME
STATEMENT
6/30 Office
Supplies (13,920)
Supplies
Expense
(13,920)
c. To record depreciation: ($46,120 $6,120) 1/120.

BALANCE SHEET
Assets
Liabilities
INCOME
STATEMENT
6/30 Accumulated
Depreciation
Equipment
(333)
Depreciation
Expense
(333)
d. To record interest on note payable.

BALANCE SHEET
Assets
6/30
Liabilities
INCOME
Interest Payable
e.

50
Interest Expense
(50)
To record salaries not yet paid.

BALANCE SHEET
Assets
6/30
STATEMENT
Liabilities
Salaries Payable
INCOME
+
620
STATEMENT

Salaries Expense
(620)
4-39

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

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

BALANCE SHEET
Assets
Liabilities
INCOME
STATEMENT
6/30 Prepaid Rent (1,000)
Rent Expense
(1,000)
2. At $1,000 per month, the original six-month payment and balance of Prepaid Rent
on April 1, 2007, was $6,000.
3. To record depreciation expense on June 30: $900 $800.
BALANCE SHEET
Assets
Liabilities
INCOME
STATEMENT
6/30 Accumulated
Depreciation (100)
Depreciation
Expense
(100)
4. Estimated useful life in months: $9,600/$100 month = 96 months.

5. To record interest expense on June 30: $864 $768.
BALANCE SHEET
Assets
6/30
Liabilities
Interest Payable
INCOME
STATEMENT

96
Interest Expense
(96)
6. Interest rate: ($96 per month 12 months)/$9,600 = 12% (annual rate). The
monthly rate is 12%/12 months = 1%.
4-40

LO 5
1. Adjustments:
BALANCE SHEET
Assets
a. Prepaid Rent
INCOME
Liabilities
(400)
Rent Expense
BALANCE SHEET
Assets
b. Accumulated
Depreciation
INCOME
Liabilities
c. Chemical
Inventory
INCOME
Liabilities
d.
INCOME
Liabilities
Wages and
Salaries
Payable
e.
Income Taxes
Payable
INCOME
+
1,881
(a) $4,800/12 months = $400/month

(b) ($18,200 $200)/120 months = $150/month
($9,400 $1,300) = $8,100
STATEMENT
Explanations:
(c)
STATEMENT
Wages and
Salary
Expense
(1,080)
1,080
Liabilities
(8,100)
BALANCE SHEET
Assets
STATEMENT
Chemical
Expense
(8,100)
(150)
BALANCE SHEET
Assets
STATEMENT
Depreciation
Expense
(150)
(400)
BALANCE SHEET
Assets
STATEMENT
Income Tax
Expense
(1,881)
4-41
(e) Calculation of taxes due:

Treatment revenue
Wages and salary expense
Utility expense
Advertising expense
Rent expense
Chemical expense
Income before tax
Tax rate
Income tax expense
$ 40,600
(23,580)
(1,240)
(860)
(400)
(150)
(8,100)
$ 6,270
0.30
$ 1,881
2. On the basis of the information available, Lewis appears to be a profitable

business. Net income for the month was $6,270 $1,881 (taxes), or $4,389. With
treatment revenue of $40,600, this results in a profit margin of $4,389/$40,600, or
approximately 11%.
ALTE R N ATE M U LTI - C O N C E P T P R O B L E M S
LO
2,3,4
PROBLEM 4-8A CASH AND ACCRUAL INCOME

STATEMENTS FOR A MANUFACTURER
1. Cash revenue: 50,000 sandwiches $2

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

earned. In the catering business, revenue is earned as the sandwiches are
delivered to the vendors. Maries might consider using the cash method to account
for sales of sandwiches if there is a significant amount of uncertainty about the
collectibility of accounts receivable.
4-42
3.
Income statement under the accrual basis:

MARIES CATERING
INCOME STATEMENT
FOR THE YEAR ENDED XX/XX/XX
Sales revenue
Cost of goods sold
Gross profit
Operating expenses:
Office salaries
Equipment depreciation
Truck depreciation
Total operating expenses
Net income
*Rent: $800 12
Raw materials
Salaries and wages
Cost of goods sold
**$10,000/10 years
***$14,000/5 years
$100,000
69,600*
$ 30,400
$ 12,000
1,000**
2,800***
$ 15,800
$ 14,600
$ 9,600
25,000
35,000
$69,600
LO 3,4
PROBLEM 4-9A REVENUE AND EXPENSE

RECOGNITION
Income statements for the first two years:
Sales revenue (a)

Expenses:
Advertising (b)
Salaries
Depreciation (c)
Rent (d)
Total expenses
Net income
SUES AUDIO BOOK RENTALS

INCOME STATEMENTS
Year 1
$ 21,000
Year 2
$ 63,000
$ 6,000
0
2,500
9,000
$ 17,500
$ 3,500
$ 4,500
12,000
2,500
9,000
$ 28,000
$ 35,000
Explanations:
a. Let X = Year 1 sales:
Year 1 sales + 3(Year 1 sales) = $84,000
4X = $84,000
X = $21,000 = Year 1 sales
3X = $63,000 = Year 2 sales
b. Total advertising expense
Less promotional portion
Total ad expense
$ 10,500
1,500
$ 9,000 or $4,500/year
Year 1 advertising = $4,500 + $1,500 = $6,000

Year 2 advertising = $4,500
c. Depreciation per year = $5,000/2 = $2,500/year
d. Rent per year = $18,000/2 = $9,000/year
4-43
4-44
LO 5,6
PROBLEM 4-10A ADJUSTMENTS AND

FINANCIAL STATEMENTS
1. Adjustments:
BALANCE SHEET
Assets
a. Prepaid
Insurance
Liabilities
INCOME
Insurance Expense
Liabilities
INCOME
Depreciation
Expense
Warehouse
BALANCE SHEET
=
Liabilities
INCOME
d.
Liabilities
Interest Payable
INCOME
e.
Liabilities
375
Customer
Deposits
f.
Liabilities
Wages and
Salaries
Payable
g.
Liabilities
Income Taxes
Payable
STATEMENT
Freight Revenue
4,500
(4,500)
INCOME
Wages and
Salary
Expense
8,200
INCOME
STATEMENT
BALANCE SHEET
Assets
(375)
BALANCE SHEET
Assets
STATEMENT
Interest Expense
INCOME
(3,125)
BALANCE SHEET
Assets
STATEMENT
Depreciation
Expense
Truck Fleet
BALANCE SHEET
=
(150)
c. Accumulated
Depreciation
Truck Fleet (3,125)
Assets
STATEMENT
b. Accumulated
Depreciation
Warehouse
(150)
Assets
(750)
(750)
BALANCE SHEET
Assets
STATEMENT
(8,200)
STATEMENT
9,237
Income Tax
Expense
(9,237)
PROBLEM 4-10A (Continued)
Explanations for adjusting entry amounts:

(a) $18,000/24 months = $750/month
(b) ($40,000 $4,000)/240 months = $150/month
(c) ($240,000 $15,000)/72 months = $3,125/month
(d) ($50,000 9%) 1/12 = $375
(g) Calculation of income tax expense:
Freight revenue
Gas and oil expense
Maintenance expense
Wage and salary expense
Insurance expense
Depreciation on warehouse
Depreciation on truck fleet
Interest expense
Income before tax
Tax rate
Income tax expense
2.
$ 170,170
(57,330)
(26,400)
(51,250)
(750)
(150)
(3,125)
(375)
$ 30,790
0.30
$
9,237
Financial statements:
(a)
TENFOUR TRUCKING COMPANY

INCOME STATEMENT
Freight revenue
Expenses:
Gas and oil
$ 57,330
Maintenance
26,400
Wages and salaries
51,250
Insurance
750
Depreciationwarehouse
150
Depreciationtruck fleet
3,125
Interest
375
Income taxes
9,237
Net income
STATEMENT OF RETAINED EARNINGS
Beginning balance, January 1, 2007
Add: Net income
$ 170,170
148,617
$ 21,553
(b)
Deduct: Cash dividends

Ending balance, January 31, 2007
$ 40,470
21,553
$ 62,023
20,000
$ 42,023
4-45
4-46
PROBLEM 4-10A (Continued)
(c)

BALANCE SHEET
JANUARY 31, 2007
Assets
Current assets:
Cash
Accounts receivable
Prepaid insurance
Land
Warehouse
Less: Accumulated
depreciation
Truck fleet
Less: Accumulated
depreciation
Total property, plant, and
equipment
Total assets
Liabilities
Accounts payable
Notes payable
Interest payable
Customer deposits
Wages and salaries payable
Income tax payable
Total liabilities
Stockholders Equity
Capital stock
Retained earnings
Total liabilities and stockholders
equity
$ 27,340
41,500
17,250
$ 86,090
$ 20,000
$ 40,000
21,750
18,250
$ 240,000
115,625
124,375
162,625
$ 248,715
$ 32,880
50,000
4,875
1,500
8,200
9,237
$ 106,692
$ 106,692
$ 100,000
42,023
142,023
$ 248,715
4-47
3. Current ratio = Current assets/Current liabilities

$86,090/$106,692 = 0.81 to 1
Tenfour may have difficulties in meeting all of its current obligations. Especially
noteworthy is the significantly higher amount of accounts receivable at year-end
compared with cash (cash and accounts receivable constitute 32% and 48% of the
current assets, respectively). It is also worth noting that the other 20% of the
current assets consists of prepaid insurance, an asset that will not be converted
into cash and thus will not help in any way to pay the current liabilities.
4. Tenfour cannot compute a gross profit ratio because it does not report cost of
sales. It is a service business rather than a product company. One possible
measure of profitability for any company is the profit margin, which is net income
divided by sales. For Tenfour, this ratio is $21,553/$170,170 or 12.7%. Many
service businesses calculate ratios that are specific to their type of business. For
example, a trucking firm might compute the ratio of revenues to miles driven.
DECISION CASES
READING AND INTERPRETING FINANCIAL STATEMENTS

LO 1,2,3
DECISION CASE 4-1 COMPARING TWO COMPANIES IN THE SAME INDUSTRY:

FINISH LINE AND FOOT LOCKER
1. According to Note 1 in its annual report, Finish Line recognizes revenue when the
customer receives the merchandise. Foot Locker indicates in its Note 1 that revenue
from stores is recognized when the product is delivered to customers. The
companies have essentially the same policy for the recognition of revenue.
2. On its February 25, 2006, balance sheet, Finish Line reports Accounts receivable,
net of $11,999,000. This comprises only $11,999,000/$627,816,000, or 1.9% of the
companys total assets. The reason that this percentage is so small is because
customers in a store such as Finish Line usually pay with either cash or a credit
card.
3. In Foot Lockers annual report, Note 8, titled Other Current Assets includes Net
receivables of $49,000,000 at January 28, 2006 (the note also reports the Current
portion of Northern Group note receivable of $1,000,000). These receivables
together represent only $50,000,000/$3,312,000,000, or 1.5% of total assets on this
date.
4-48
DECISION CASE 4-1 (Concluded)
4. The two approaches differ in that Foot Locker chooses to report a single Property
and Equipment account on its balance sheet with Note 9 showing the individual
amounts for the items, such as furniture, fixtures, and equipment, which make up
this asset. Companies have flexibility as to whether they report this information
directly on the balance sheet or instead in one of the notes to the statements.
LO 3
1.
DECISION CASE 4-2 READING AND INTERPRETING SEARS,

ROEBUCKS NOTESREVENUE RECOGNITION
Under the accrual basis, revenue should be recognized when it is earned rather
than when cash is received. Over the life of a service contract, the retailer will incur
costs to repair damaged merchandise. The retailer earns revenue over the life of
the service contract.
2. Revenue to be recognized each year:
Sales revenue
Service contract revenue
Total revenue
Year 1
$2,320*
60**
$2,380
Year 2
$
0
60
$ 60
Year 3
$ 0
60
$ 60
Total
$ 2,320
180
$ 2,500
*$2,500 $180
**$180/3 years
When a retailer sells a service contract, it receives cash and at the same time
incurs a liability to provide service in the future. Thus, on its balance sheet, it will
report a liability account for work to be performed under service contractsa form
of unearned revenue. This account tells the reader the amount of revenue to be
recognized in the future under service contracts.
In this particular example, the liability account would contain $120 and $60 at
the end of Years 1 and 2, respectively, to report the amount of unearned revenue.
4-49
MAKING FINANCIAL DECISIONS
LO 2,3,4
1.
DECISION CASE 4-3 THE USE OF NET INCOME

AND CASH FLOW TO EVALUATE A COMPANY
DUKE INC.
STATEMENT OF CASH FLOWS
FOR THE YEAR ENDED DECEMBER 31, 2007
Operating Activities:
Cash received from services
provided to clients
Cash paid for:
Salaries and wages
Supplies
Utilities
Rent
Net increase in cash
$ 1,020,000*
$ 440,000**
100,000
30,000
180,000***
$
750,000
270,000
*$1,250,000 $230,000
**$480,000 $40,000
***$10,000 18 months
Note to Instructor: You may want to point out to students that the net increase in cash
is also the net cash provided by operating activities for the year. That is, there are no
investing or financing activities because the acquisition of the computer system by the
signing of a promissory note did not result in any net change in cash, if it is assumed
that the note was signed directly with the computer vendor. The transaction would not
appear directly on a statement of cash flows but instead on a supplementary schedule.
2. One important question to be asked is whether it is possible for the company to
continue to generate service revenues in succeeding years at the level attained in
its first year. The ability to collect the revenues billed in 2007, but not yet collected
($230,000), should also be a concern. On the basis of the cash flows generated in
the first year, the business appears to be worth strong consideration. One major
concern, however, is whether the company will be able to repay the note in 2010. It
must generate sufficient cash flows over the next three years (this includes the year
just concluded) to repay $1,725,000 in principal and $414,000 ($138,000 per year
3 years) in interest. This may be very difficult to do unless more cash flow is
generated from operations or the company is able to negotiate an extension of the
due date for the loan.
4-50
LO 4
DECISION CASE 4-4 DEPRECIATION
The decision to purchase or lease long-term assets is a difficult one for all businesses
and requires an analysis of all the relevant facts. Rapidly changing technology may
make it less risky to lease computer equipment than to purchase it. This is certainly a
key consideration in this particular case. Jenner also needs to consider maintenance
costs. The case does not indicate whether Jenner would be responsible for
maintenance if it leases the equipment. Another relevant factor would be whether the
equipment would have any salvage value at the end of its useful life.
Note to Instructor: This may be an opportune time to raise the issue whether certain
leases should be capitalized as assets. Given the students understanding of the nature
of an asset, do they think some long-term leases possess the characteristics to qualify
for treatment as assets?
Depreciation is the process of allocating the cost of a long-term tangible asset over its
useful life. Because of rapidly changing technology, computer equipment presents a
challenge to the accountant in determining economic life. Even though the equipment
may last for 10 to 20 years before it physically wears out, its economic life may be
much shorter than that because of technological obsolescence. In this particular case,
a life of three to five years, possibly four years, seems to be warranted.
ETHICAL DECISION MAKING
LO 2,3,4,5
DECISION CASE 4-5 REVENUE RECOGNITION AND

THE MATCHING PRINCIPLE
1. If sales are recorded but the commissions associated with these sales are not
recorded during the month of June, net income will be larger by the understatement
of commissions expense. The failure to record advertising expense for the month of
June will also result in an understatement of expense and an overstatement or
increase in net income. Finally, an increase in the estimated useful life of the
automobiles will result in a decrease in the amount of depreciation expense and
thus an increase in net income.
4-51
DECISION CASE 4-5 (Concluded)
2. The first suggestion, to delay recording the 4% commission expense until July, is a
clear violation of the matching principle. Regardless of when the sales staff is paid
commissions, it is wrong to record the revenues in June but not record the expense
associated with earning that revenuei.e., commissionsuntil July. Likewise,
deferring the recognition of the advertising bill as an expense until July also
violates the matching principle. Under the matching principle, this cost should be
recognized as an expense in the period in which it provides benefits (in this case,
the month of June), regardless of when cash is paid. Finally, the change in
estimated useful life for the automobiles is also questionable from an accounting
point of view. Companies are allowed under generally accepted accounting
principles to change estimated useful lives of depreciable assets, but the changes
must be justified on sound economic grounds. For example, changes in technology
might prompt a company to decrease the estimated useful lives of its computers.
The need to increase the net income for the year is certainly not an acceptable
reason under GAAP to change the estimated useful lives of depreciable assets.
The changes suggested result in financial statements that do not faithfully
represent what they claim to represent and are not merely minor bookkeeping
changes. Readers assume that the statements are prepared on an accrual basis
rather than a cash basis. Also, they assume that the company is consistent in the
way it depreciates assets from one period to the next.
3. Each of the three suggestions involves a question of ethics. All three involve an
attempt to consciously overstate income for the purpose of obtaining a loan, and
the decisions made by the owners provide information that is biased toward making
the company look better. There is an attempt on the part of the vice-president of
sales to deceive a user of the accounting information. The banker relies on the
trustworthiness of the company to accurately report its income, and each of the
three suggestions would violate that trust. The company would not be acting in
good faith if it were to report income as has been suggested. The vice-president
has suggested changes that are intended to overstate net income for the purpose
of receiving the loan.
4. The controller may benefit in the short-term by making the proposed changes (he
gets to keep his job and his Cadillac). But in the long-term his professional
reputation will be harmed when the bank realizes that he misstated income to
mislead the bank and receive the loan. If the bank approves the loan based on
overstated net income, the bank will be harmed. The interest rate of the loan will
not properly reflect the risk of the company. Any outsiders who rely on the financial
statements will be harmed. When net income is overstated, future cash flows are
also overstated and outsiders who rely upon the incorrect financial statements may
make the wrong decisions about the company (e.g., extend credit when they should
not).
4-52
LO 4
DECISION CASE 4-6 ADVICE TO A POTENTIAL INVESTOR
The financial statements contain two major errors that prevent them from being in
accordance with generally accepted accounting principles. First, if the normal balance
of supplies on hand is $1,000, Century should recognize supplies expense on its
income statement for $16,500 (the amount of supplies on its balance sheet) less
$1,000, or $15,500. Second, it should also recognize depreciation expense of $35,000
over seven years, or $5,000, on the equipment. These two adjustments would result in
revised net income as follows:
Net income reported
Supplies expense
Revised net income (loss)
$ 10,500
(15,500)
(5,000)
$ (10,000)
The company was able to generate significant revenues from its services during the
first year. Given this level of revenues, however, it was not able to control its costs,
particularly its salaries and wages. On the basis of these financial statements alone, it
would be difficult to advise anyone to invest in the company. In addition to the
information given, the investor would want to know more about the nature of the
company's business (its markets, customers, pricing structure, etc.) and the industry in
which it operates.
REAL WORLD PRACTICE 4.1

Foot Locker reports in Note 8 Prepaid expenses and other current assets of
$47,000,000 and $46,000,000 at the end of 2004 and 2005, respectively. The types of
prepaid expenses a company such as this might have include various prepayments,
such as insurance and rent, and various types of supplies, such as cleaning and office
supplies.
REAL WORLD PRACTICE 4.2

According to Note 11 Accrued Liabilities in Foot Lockers report, the largest item at
the end of 2004 was Other operating costs and the amount was $55,000,000. At the
end of 2005, the largest item was Pension and postretirement benefits of
$72,000,000. The account Accrued and other liabilities appears as a current liability
on the balance sheet. The total amounts for accrued liabilities in the note are
$285,000,000 and $305,000,000 at the end of 2004 and 2005, respectively. These
same amounts appear on the balance sheets at the end of the two years.
4-53
SOLUTION TO INTEGRATIVE PROBLEM

Part 1
1. Effects on the accounting equation are as follows:
BALANCE SHEET
Assets
a.
Liabilities
Salary and
Wages Payable
INCOME
4,000
BALANCE SHEET
Assets
Liabilities
Supplies
Expense
BALANCE SHEET
=
Liabilities
INCOME
Liabilities
INCOME
e. Extended
Warranty
Liabilities
INCOME
Liabilities
INCOME
Medical Services
Revenue
BALANCE SHEET
g.
STATEMENT
f. Billings Receivable,
Net
16,000
Assets
STATEMENT
Extended Warranty
Expense
(3,000)
(3,000)
(10,000)
BALANCE SHEET
Assets
STATEMENT
Depreciation
Expense
Building
BALANCE SHEET
=
(30,000)
d. Accumulated
Depreciation
Building
(10,000)
Assets
STATEMENT
Depreciation
Expense
Automobiles
BALANCE SHEET
=
(64,347)
c. Accumulated
Depreciation
Automobiles (30,000)
Assets
STATEMENT
b. Medical
Supplies (64,347)
Assets
Salary and
Wages Expense (4,000)
INCOME
STATEMENT
Liabilities
Interest Payable
INCOME
16,000
STATEMENT
3,000
Interest
4-54
Expense
3,000
INTEGRATIVE PROBLEM (Continued)
2.
MOUNTAIN HOME HEALTH INC.

INCOME STATEMENT
Revenues:
Medical services revenue
Expenses:
Salary and wages expense
Supplies expense
Gasoline expense
Utilities expense
Interest expense
Depreciation expenseautomobiles
Depreciation expensebuilding
Extended warranty contract expense
$ 566,000
$292,000
64,347
137,500
12,000
3,000
30,000
10,000
3,000
551,847
$ 14,153
Net income
RETAINED EARNINGS STATEMENT
Beginning balance
Add: Net income
Deduct: Dividends
Ending balance
$ 99,900
14,153
(10,000)
$ 104,053
4-55
INTEGRATIVE PROBLEM (Continued)
3.

BALANCE SHEET
AS OF DECEMBER 31, 2006
Assets
Current assets:
Cash
Billings receivable, net
Medical supplies
Building
Less: Accumulated depreciation
Total assets
Liabilities and Stockholders Equity
Accounts payable
Interest payable
Salary and wages payable
Dividend payable
Long-term liabilities:
Mortgage payable
Total liabilities
Stockholders Equity
Capital stock
Additional paid-in capital
Retained earnings
Total liabilities and stockholders equity
$ 77,400
167,000
8,653
$ 253,053
$ 200,000
(60,000)
140,000
$ 393,053
$ 22,000
3,000
4,000
10,000
$ 39,000
100,000
$ 139,000
$ 100,000
50,000
104,053
254,053
$ 393,053
4. a. Working capital: $253,053 $39,000 = $214,053

b. Current ratio: $253,053/$39,000
6.5 to 1
5. By their nature, all adjustments cause a difference between the amount of income
recognized on an accrual basis and that recognized on a cash basis. The
adjustment for wages and salaries, and interest, result in decreases in income in
the current period with a delay in the outflow of cash until a later period. Similarly,
the adjustment for service revenue represents revenue earned currently but
delayed until a later period in the receipt of cash. Conversely, the adjustments for
depreciation, warranties, and supplies used represent the recognition of expense in
the current period for cash outlays in an earlier period.
4-56
INTEGRATIVE PROBLEM (Concluded)
6. Supply of cash needed:

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

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CHAPTER 4

Income Measurement and

1. Explain the significance of recognition and measurement

2. Explain the differences between the cash and accrual

3. Describe the revenue recognition principle and explain its

4. Describe the matching principle and the various methods

5. Identify the four major types of adjustments and determine

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

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

FINANCIAL ACCOUNTING SOLUTIONS MANUAL

5. Identify the four major types of adjustments and determine

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

1. Explain the significance of recognition and measurement

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

CHAPTER 4 INCOME MEASUREMENT AND ACCRUAL ACCOUNTING

1. Explain the significance of recognition and measurement

2. Explain the differences between the cash and accrual

3. Describe the revenue recognition principle and explain its

4. Describe the matching principle and the various methods

5. Identify the four major types of adjustments and determine

FINANCIAL ACCOUNTING SOLUTIONS MANUAL

This statement is not entirely accurate. Because it is based on historical cash

The time period assumption is important in accounting because financial

CHAPTER 4 INCOME MEASUREMENT AND ACCRUAL ACCOUNTING

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

The four basic types of adjustments are:

FINANCIAL ACCOUNTING SOLUTIONS MANUAL

EXERCISE 4-1 REVENUE RECOGNITION

Cash collected at toll booth

EXERCISE 4-2 THE MATCHING PRINCIPLE

CHAPTER 4 INCOME MEASUREMENT AND ACCRUAL ACCOUNTING

EXERCISE 4-3 ACCRUALS AND DEFERRALS

EXERCISE 4-4 OFFICE SUPPLIES

To record office supplies used.

Stockholders Equity + Revenues Expenses

5/31 Office Supplies

EXERCISE 4-5 PREPAID RENTQUARTERLY

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

Stockholders Equity + Revenues Expenses

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

Stockholders Equity + Revenues Expenses

FINANCIAL ACCOUNTING SOLUTIONS MANUAL

EXERCISE 4-6 DEPRECIATION

1. To record purchase of combine on July 1.

Stockholders Equity + Revenues Expenses

7/1 Equipment 100,000

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

Stockholders Equity + Revenues Expenses

EXERCISE 4-7 PREPAID INSURANCEANNUAL

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

Stockholders Equity + Revenues Expenses

CHAPTER 4 INCOME MEASUREMENT AND ACCRUAL ACCOUNTING

EXERCISE 4-7 (Concluded)

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

Stockholders Equity + Revenues Expenses

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

EXERCISE 4-8 SUBSCRIPTIONS

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

Stockholders Equity + Revenues Expenses

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

Stockholders Equity + Revenues Expenses

FINANCIAL ACCOUNTING SOLUTIONS MANUAL

EXERCISE 4-9 CUSTOMER DEPOSITS