(Solution Manual) Core Concepts of Accounting

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CHAPTER 1 SOLUTIONS TO END OF CHAPTER MATERIAL QUESTIONS 1. The three general types of business are typically categorized as follows: service, manufacturing and merchandising. Service example: airline company , e.g. Southwest Manufacturing example: steel manufacturing company , e.g. US Steel Merchandising example: wholesaler company , e.g. Costco 2. The three common forms of business organizations are sole proprietorships, partnerships and corporations. The major differences between these form s of busines s organizations are in terms of owne rship, liability and taxation. A sole proprietorship is owned by a single individual, who has unlimited liability ; profits of the proprietorship flow through to the owner, who individually pays taxes on those profits. A partnership is owned by two or more individuals , who each have unlimited liability . Profits of the business flow through to the partners , who individually pay taxes on their specific share of those profits. A corporation is owned by stockholders ; liability for organizational debts is limited to the amount of funds invested by owners , who cannot be held individually responsible for the debts. A corporation files a tax return and pays taxes. (Stockholders receiving dividends from a corporation commonly must p ay taxes on those dividends…even though the corporation paid taxes on the profits from which the dividends are paid. Thus, it is said that corporate profits are effectively taxed twice: once upon being earned and once upon being distributed.) The most com mon form of business in the United States is the sole proprietorship. 3. The primary function of a business’s accounting function is to provide quantitative information, primarily financial in nature , about economic entities. The information is intended to be useful in making economic decisions for internal and external users of the information. 4. The four major financial statements are the balance sheet, income statement, statement of cash flows and statement of stockholder’s equity. Balance Sheet: Summa rizes the assets (resources an organization owns), liabilities (debts that the organization owes), and stockholders’ equity (amounts owners have contributed and the net amount that the entity has earned for them) of an entity at a specific time. Income St atement: Summarizes a business’s revenues and expenses for a specific time period. Statement of Cash Flows: Reveals how a business generated and spent cash during a given accounting period. Businesses issue financial statements because financial statemen ts provide information about an organization’s financial performance over a period of time. These statements are useful to third parties such as investors, bankers, CEOs and management during their decision making. 5. This statement is false because a compa ny’s fisc al year may begin on any date. For example, the Walt Disney Company has a fiscal year that runs from October 1 to September 30. 6. The three types of activities are operating , investing, and financing. Operating activities: Reflect the d ay-to-day a ctivities of a business that generate revenues by providing products or services and that create the costs of generating those revenues Investing activities: Involve the acquisition and sale of (1) long -term assets used in the business and (2) non -operati ng investment assets Financing activities: Involve cash inflows and outflows from transactions with creditors and investors. The Statement of Cash Flows uses the above three business activities as section headings. 7. GAAP is a group of accounting rules, c oncepts and principles that are used as a standard framework of guidelines in the prepar ation of financial statements. GAAP’s primary purpose is use as a guideline in conducting and revi ewing accounting transactions. The FASB is the principal accounting bo ard in charge of establishing GAAP. 8. Private accounting involves internal wor k within a business entity, not -for-profit organization , or government agency. P ublic accounting involves external work as an independent firm with various firms in business. Individuals in private accounting may have job titles such as controller, internal auditor, financial accountant, cost analyst and tax accountant. 9. Public accounting firms offer auditing, tax preparation and advice, certain types of consulting, and bookke eping services. Auditing is the most important service offered by public accounting firms because it involves the determination of the fairness, fullness and compliance with GAAP for financial statements and ac counting records of companies. These financ ial statements provide third parties with vital information in the making of economic decisions. 10. The collapse of the stock market in 1929 led Congress to establish the SEC in the early 1930s with the intent to deter the abusive accounting and financial re porting practices that contributed to the stock market’s collapse. The SEC ensures that publicly owned companies provide third parties with sufficient information to make informed economic decisions regarding the securities these firms sell. EXERCISES 11. (a) T (b) T (c) F The FASB is the board that issues most of the new accounting rules in the U.S. (d) F Corporations account for the most business revenues each year . (e) T (f) F The Balance She et is a statement of position at a specific point in time ; the Income Statement and the Statement of Cash Flows cover a fiscal year. (g) T (h) T (i) F Accounting contributes significantly to the success of business organizations by providing useful information on the transactions and results of transactions for those entities. (j) T (k) F Owners of LLPs, LLCs, and Subchapter S corporations pay taxes for their companies. 12. (a) (1) M (2) S (3) S (4) R (5) M (b) (1) Determine the estimated amount of goods needed to be produced to meet the market demand of products. Accountants can provide the inventory accounts balances. (2) Determine the amount of cash from operations. Accountants can provide the Cash Flow from operating activities statement. (3) Determine the ability of a customer to repay loans. A ccountants can analyze the customer’s financial statements. (4) Determine the growth in revenues during the last fiscal period. Accountants can compare the income statement of the current fiscal period and the preceding fiscal period. (5) Determine the cost of manufacturing a product. Accountants can calculate the total costs incurred in the manufacturing of a product. 13. (a) Proprietorship vs. Corporation Advantages ▪ no double taxation ▪ easy to start up ▪ cheap to establish ▪ no particular record keeping requirements ▪ no one to share profits with Disadvantages ▪ self-employment tax rate ▪ unlimited liability ▪ lack of financing strength (b) Partnership vs. Corporation Advantages ▪ no double taxation ▪ easy to set up ▪ can establish with friends or relatives Disadvantages ▪ unlimited liability ▪ joint and several liability (c) LLP (limited liability partnership) ; LLC (limited liability company) ; and Subchapter S (Sub S) corporation The distinguishing characteristics of these forms of business organizations are tha t they possess key featur es of other forms of business. Each of these business types is a hybrid between a corporation and a partnership. O wners are provided with limited liability (as in a corporation ) and are only taxed as individuals (as in a partnershi p). 14. (a) Net Income – Management Inventory cost per unit – Retailer Total liability – Loan Officer Total sales by geographical area of business operations – Marketing department Five-year trend in total sales – Investor Employee salaries by depa rtment – Management (b) To measure profitability of company To determine selling price per unit To measure risk of business To understand the market of product To determine stability of company To allocate payroll by department 15. TO: JIM HARDY FROM: ACCOUNTANT S DATE: JULY 1, 20X1 SUBJECT: FINANCIAL STATEMENTS It has come to our attention that your business, Jim’s Bike Shop, has not been keeping any accounting records of its financial activity since operations commenced. Financial statements are an integral part of any business organization. These statements reflect the company’s revenues and e xpenses and, thus, profitability, for a specific period. The financial statements also show the company’s financial position through detailing t he assets owned, liabilities owed, and the capital balances of the owner. T he company’s cash flow is also reflecte d in the financial statements, so that it is apparent where money is being generated and used. The statements provide readers with useful information necessary to make vital economic decisions. The information needs to be provided in a timely manner for it to be useful. Thus, there is an urgent need for you to prepare monthly financial statements for your business. With reasonably accurate and timely financial statements users can easily determine the profitability and risk of your business. You can also keep track of your income, expenses, cash flows , assets , and debts . 16. Transactions : Assets = Liabilities + Equity (a) Purchased eq uipment for $12,500 cash +$12,500 – $12,500 = $0 + $0 (b) Fuente & Demond bought additional $17,000 of stock in firm $17,000 = $0 + $17,000 (c) Paid $1,500 owed to an office supply store for a purchase made the previous month -$1,500 = -$1,500 + $0 (d) Purchased supplies for $4,000 on credit $4,000 = $4,000 + $0 PROBLEMS 17. (a) (1) Stockholders: Determine return on investment; estimate future returns and profitability (2) Executives: Determine the next year’s budget ; whether the company met its current financial objectives (3) Bankers: Determine ability to repay loans and pay for purchases. (b) (1) Stockholders: Why the rate of return on revenues is so low (2) Executives: The interest rate and tax rate the company is paying; the proporti on of operating expenses that is cost of goods sold; what comprises “other revenue” (3) Bankers: Why the rate of return on revenues is so low; how the company intends to decrease costs in future years 18. (a) Lifestyle Magazines Total Net Income = ($207 ,300,000 + $246,300,000 + $264,000,000 ) = $717,600,000 Big Win = $45,360,000 Quick & Yummy Foods = $288,019,000 (b) BigWin Hotel & Casino = [(2009 NI – 2007 NI) ÷ 2007 NI] = [$18,745,000 – $10,649,000) ÷ $10,649,000] = $8,096,000 ÷ $10,649,000 = 76.03 % Lifestyle Magazines = $56,700,000 ÷ $207,300,000 = 27.35% Quick & Yummy Foods = $29,553,000 ÷ $80,517,000 = 36.70% (c) Lifestyle Magazine ▪ Customer demand affected by other competitors ▪ Customer demand affected by presence of alternative sources like the internet BigWin Hotel & Casino ▪ Barriers of entry to industry create a monopoly situation ▪ State rules and regulations affect profitability of business Quick & Yummy Foods, Inc. ▪ Easy entry into industry creates competition ▪ Location of restaurants vital to profitability ▪ Food is generally perishable , thus small prof it margins are realized by food industry 19. (a) Assets = Liabilities + Equity $510,000 = a + $318,000 a = $510,000 - $318,000 a = $200,000 (b) Net Income = Revenues - Expenses b = $510,000 - $320,000 b = $190,000 (c) Assets = Liabilities + Equity c = $430,000 + $320,000 c = $770,000 (d) Net Income = Revenues - Expenses $210,000 = $870,000 - d d = $660,000 (e) Assets = Liabilities + Equity $950,000 = $367,000 + e e = $950,000 - $367,000 e = $583,000 (f) Net Income = Revenues - Expenses $331,000 = f - $678,000 f = $331,000 + $678,000 f = $1,009,000 20. (a) Selling Price – Cost = $3,0 00,000 = $1,000,000 = $2,000,000 loss (b) $2,000,000 ÷ 5 years = $400,000 per yea r (c) The special accounting treatment for losses on sale of certain securities is misleading to financial statement users because net income is overstated during the ye ar of loss on sale and understated in succeeding years when the loss is offset by income. CASES 21. (a) Year begins on December 1st Year ends on November 30th (b) Balance sheet information = 2 years (c) Income statement information = 3 years (d) Cash flow information = 3 years (e) Shareholders’ equity information = 3 years (f) (1) Balance Sheet 2007, Statement of Cash Flows 2007 (2) Statement of Cash Flows 2007, Balance Sheet 2006 (3) Balance Sheet 2007, Statement of Shareholders’ Equity 2 007 (4) Income Statement 2007, Statement of Shareholders’ Equity 2007 (5) Balance Sheet 2007, Statement of Shareholders’ Equity 2007 (g) PricewaterhouseCoopers LLP 22. (a) The Securities Exchange Commission has statutory authority to establish finan cial accounting and reporting standards for publicly held companies under the Securities Exchange Act of 1934. (b) Since 1973 (c) The mission of FASB is to establish and improve standards of financial accounting and reporting for the guidance and educ ation of the public, including issuers, auditors and users of financial information. (d) As of November 2009 , it was Robert H. Herz . Current board personnel can be checked at http://www.fasb.org . (e) Ways topics are added to the FASB agenda ▪ Pervasivene ss of the issue ▪ Alternative solutions ▪ Technical feasibility ▪ Convergence possibilities ▪ Cooperative opportunities ▪ Resources (f) Upon reaching conclusions on researched issues, the FASB prepare s a proposed Exposure Draft for consideration by the Board. After further discussion and revisions, Board members vote whether to issue the Exposure Draft. A majority vote of the Board is required to approve a document for issuance as an Exposure Draft. Alternative views, if any, are explained in the document and posted on the FASB website. The Exposure Draft sets forth the proposed standards of financial accounting and reporting, the proposed effective date and method of transition, background information, and an explanation of the basis for the Board’s conclusions. At the end of the exposure period, comment letters and position papers are analyzed to search for new information and persuasive arguments regarding the issues (rather than being simply a "nose count" of how many support or oppose a given point of view ). In addition to studying this analysis, Board members review the comment letters to help them in reaching conclusions. When the Board is satisfied that all reasonable alternatives have been considered adequately, the staff is directed to prepare a draft of a final document for consideration by the Board. (g) This answer depends on the point in time that the web site is searched. CHAPTER 2 SOLUTIONS TO END OF CHAPTER MATERIAL QUESTIONS 1. The principal focus of financial accounting is to serve the need s of external decision - makers. These users need financial data about a business to make sound economic decisions. External partie s, such as investors, lenders, and other groups (such as the IRS and regulatory bodies ) benefit from standardized financial reporting in that information is consistent fro m year to year and comparable fro m company to company. 2. The balance sheet equatio n is Assets = Liabilities + Owners’ Equity Assets represent all the items owned by a company. Assets have future economic value in that they can be converted to cash or used to generate revenues. Most assets are tangible and have some type of physical sub stance. However, some assets such as accounts receivable, patents, and leases have no true physical substance except to be represented by a document . Liabilities represent all debts owed by a company to other companies or individuals. All that a company has (assets) minus all it owes (liabilities) is a company’s worth , which is known as owners’ equity. Equity can come from two sources. It can be contributed by owners; for example, an owner gives $10,000 of his personal money to the company in exchange for $10,000 of company equity . Or e quity can also be generated by a profitable company. 3. The operating cycle is determined by the time period between the use of cash for normal business operating activities and the receipt or collection of cash from the e ntity’s customers. The operating cycle for a homebuilder could be three to six months, while the operating cycle for winery could be over a year or more. The operating cycle for a service firm could be a matter of days or weeks. On the balance sheet, a ssets are classified as current (typically listed first in balance sheet order) if those items will be converted into cash, sold, or used up within the next year or operating cycle, whichever is longer. 4. Retained Earnings does not contain cash. This account is a representation of how the equity in a business has increased bec ause of profitable operations. Each year, the net profit is added to Retained Earnings; profit equals revenues earned minus both the cost s of doing business (expenses) and any distributions to owners (dividends) . If there is a net loss, it is deducted from Retained Earnings. Therefore, Retained E arnings is the sum of yearly [revenues – expenses – dividends] since the company began. 5. The income statement is a “period -of-time” statement because the statement will reveal what revenues were earned and expenses incurred during a defined period (e.g., a month or a year). The statement of cash flows and the statement of stockholders’ equity are also “period -of-time” statements. In co ntrast, the balance sheet is a “point -in-time” statement in that it shows the assets, liabilities, and stockholders’ equity at only one specific moment in time. “Period -of-time” statements allow the user to understand what happened over time, while “point -in-time” statements give information that presents a single moment. 6. Revenues are increases in assets or decreases in liabilities that result from the profit - oriented activities of the business. Gross profit is the difference between the net reven ues generated and the cost of goods sold during a particular period. Net income is computed by subtracting opera ting expenses from gross profit and is also known as the “bottom line ” of the income statement. Net income is commonly known as profit. 7. Answer s will vary based on companies chosen. 8. The common theme of the three financial reporting objectives of business entities is the need for the financial statements to provide external parties the necessary information to make informed decisions about ec onomic events. Without this information, users of financial statements would not be to make appropriate business and investment decisions. 9. Accounting information that is deemed to be reliable has the following three characteristics: verifiab ility, neutrality, and representational faithfulness. To be verifiable, accounting information should be able to be validated by more than one person . To be neutral, accounting informa tion must be without bias. To be representational ly faithful , accounting information must express the business’ s true economic resources, obligations, and transactions. 10. The principal reason that historical cost is used as the basis for assets is that it can be verified thorough documentation (bill of sale, etc.). Current values may differ depending on whose opinion is obtained. The use of historical costs could result in the undervaluation o f assets on the balance sheet. Alternatively, liabilities are generally current amounts. This differentiation in valuations causes a net “book value” that bo rders on meaningless. 11. Revenues should be both realized (assets exchanged for cash or a claim to cash) and earned (provided a product or service) before they are entered in the accounting records of an entity. There are some instances where the poin t of sale rule does not apply. For example, many construction projects create economi c impacts over multiple years. In such cases, revenues may need to be spread over several accounting periods rather than recorded totally at the e nd of the project. 12. A general journal contains a chronological listing of transactions and how these transactions affected individual accounts. A general ledger contains individual accounts and shows all the changes made to the account by transactions. Two separate records are used because events occur that alter two or more accounts simultaneously. A record of the event is found in the general journal. However financial reporting is done on an account basis, so the general journal is used to track c hanges to individual accounts. A general ledger facilitates for the posting of journal entries into individual accounts and this easies the process of compiling financial statements. EXERCISES 13. (a) F Intangible assets are not current assets; they wil l not be used up or converted to cash within one year. (b) T Unfortunately, however, management may engage in improper accounting to shift revenues and expenses into inappropriate time periods. (c) T (d) F Revenues minus expenses is equal to net income . Or revenues minus cost of goods sold is equal to gross profit. (e) F This statement describes the full -disclosure principle. (f) T (g) F Matching refers to the presentation of expenses related to recognized revenues on the income statement . (h) T (i) F The statement that reconciles beginning and ending cash is the Statement of Cash Flows. (j) T (k) F Business transactions are recorded in the general journal and then posted to the general ledger. (l) F The a ccounting cycle is not always longer th an a company’s operating cycle. For example, construction projects and some food products (such as those that must be aged) may have an accounting cycle that is shorter than the operating cycle. 14. (a) A = L + SE A = L + $2,000,000 2X = X + $2,000,000 X = $1,000,000 = Liabilities A = $2,000,000 (b) SE = $ 2,000,000 SE = CS + PIC + RE $2,000,000 = $958,000 + RE RE = $1,042,000 15. Intangible asset s long term asset Accounts payable current liability Inventory current asset Cash current asset Notes payable (due in ten years) long term liability Prepaid expenses current asset PPE long-term asset Common stock stockholders’ equity Accounts rec eivable current asset Retained earnings stockholders’ equity Notes payable (due in six months) current liabi lity Additional paid -in capital stockholders’ equity 16. (a) Cash, Short -term investments, Accounts receivable, Inventory, Prepaid expenses (b) Assets should be listed on the balance sheet in order of liquid ity or the ability to turn the assets into ca sh. The more liquid the asset, the closer to the top of the current asset list it should appear. 17. (a) At the end of the current year, Farewell should report $90 ,000 a s a long -term liability, and $30 ,000 in the current liability section of the balance sheet. (b) It is important to accurately list the items o n the balance sheet so that current and potential creditors and assess the ability of the firm to pay its debts as they come due. 18. (a) Two factors that might contribute to the difference in gr oss profit for the companies might include the types of shoes that are carried by each wholesaler, the distribution chains that are used by each wholesaler, and the size of the orders placed by each wholesaler ’s retailing clients. The stores might also hav e different suppliers of merchandise, which could contribute to a difference in respective cost of goods sold. (b) As president of Company B, I might investigate the cost of the company’s goods (shoes), try to find more reasonable suppliers of merchandis e, investigate the possibility of reducing overhead or distributions costs, and sell in larger quantities to retailers …all of which should lower some costs. 19. Operating items are generated from operating activities ( that is, by providing a prod uct or service to a customer). Nonoperating items are generated from investing and financing activities or by events incidental to the operations of a business. These definitions provide the rationale for the items below. Sales revenue operating revenue Cafeteri a revenue nonoperating income Interest revenue nonoperating income Cost of goods sold operating expense Utility expense operating expense FICA (Social Security) matched amounts operating expense (part of salaries/wages) Shipping expense operating expense (relates to inventory) Income tax expense nonoperating expense Property tax expense operating expense (assume on property in use in the business, such a manufacturing facility or headquarters) 20. Gross Profit = Revenues – Cost of Goods Sold Gross Profit = $750,000 - $480,000 Gross Profit = $2 70,000 Gross Profit Percentage = Gross Profit ÷ Revenues Gross Profit Percentage = $270,000 ÷ $7 50,000 Gross Profit Percentage = 36% Oehlke Co. may not have a high enough markup on the pr oduct , especially given how high salary costs are in the business. After paying f or the product, Oehlke only has 36% of what customers paid for the goods , and Oehlke still has to pay other expenses out of that. 21. (a) relevance (b) materiality (c) comparability (d) understandability (e) reliability 22. (a) The operating cycle would be 13 5 days. (90 days + 35 days) (b) Normal ly, anything that is receivable or payable within the accounting cycle is classified as current; anything receivabl e or payable beyond the accoun ting cycle is classified as long term. 23 Several common examples of accrued liabilities at the end of an accounting cycle are salaries owed to employees for work already performed, interest on notes payable , local/state/federal taxes, and utilities . PROBLEMS 24. (a) Gross Profit = Net Sales – Cost of Goods Sold Gross Profit = $315,000 - $130 ,750 Gross Profit = $184 ,250 Operating Income = Gross Profit – SG&A Exp. Operating Income = $184,250 - $90,050 Operating Income = $53,5 00 Income before Tax es = Operating Income + Interest Revenue Income before Taxes = $53,5 00 + $5,000 Income before Taxes = $58,5 00 Net Income = Income before Taxes – Income Tax Expense Net Income = $58,500 - $2,500 Net Income = $56,000 (b) Valimer Corporation Income Statement For Period Ended Date Net Sal es $315,000 Cost of Goods Sold (130,750) Gross Profit $184 ,250 Selling and Administrative Expenses (90,050) Operating Income $ 94,250 Interest Revenue 5,000 Income Before Income Taxes $ 99,250 Income Tax Expense 2,500 Net Income $ 96,75 0 25. (a) $35,000 ÷ 5 years = $7,0 00 per year. (b) $7,000 per year x 3 years = $21,000 of Accumulated Depreciation (c) The matching principle req uires that revenues generated in a particular accounting cycle be matched with the expenses incurred during that same accounting cycle. This purchase reflects an item that should be capitalized and depreciated over the life of the asset rather than expens ed immediately on the income statement. 26. (a) Revenue per unit = 2 x cost per unit Revenue per unit = 2 x $27.50 Revenue per unit = $55.00 Sales (2008 ) = units sold x revenue per unit Sales (2008 ) = 10,000 units x $55 Sales (2008 ) = $550,000 (b) Cost o f Goods Sold (CGS) = units sold x cost per unit CGS = 10,000 x $27.50 CGS = $275,000 Gross Profit = Sales (2008 ) - CGS Gross Profit = $550,000 - $275,000 Gross Profit = $27 5,000 (c) Gross Profit = Sale s – CGS Sales (2009 ) = CGS + Gross Profit Sales (2009 ) = $225,000 + $200,000 Sales (2009 ) = $425,000 Gross Profit % = Gross Profit ÷ Net Sales Gross Profit % = $200,000 ÷ $425,000 Gross Profit % = 47.1% 27. (a) The ending balance s on the Statement of Stockholders’ Equity for Common Stock, Additional Paid -In Capital, and Retained Earnings are presented on the balance sheet in the Stockholders’ Equity section. (b) The s ale of common stock accounted for an increase in stockholders’ equity of $540,000 (p ar value of $240,000 + additional paid -in capital of $300,000). 28. (a) Green Realty Corp. probably uses this format because the real estate industry’s most impor tant asset is its investments. Cash and other types of current assets appear to be almost insignificant amounts to Green Realty . (b) Restricted cas h would primarily consist of security deposits held on behalf of tenants as well as capital improvement and real estate tax escrows required under certain loan agreements. (c) Comparability would not exist within the industry if Green Realty Corp. uses a different format for its balance sheet. 29. (a) Potential investors might want to have prior years’ audited financial statements, detailed information about current obliga tions ( both short -term and long -term), and ratio analysis for liquidity. They may also want to see projections for the future, including information about the city/state/country economic health. (b) The audited financial statements should help satisfy the following objectives: (1) providing information that is useful in making in vesting and lending decisions, (2) providing information about assets, liabilities and other transactions that might impact these items, and (3) providing information to allow decision makers to help predict future cash flows. (c) The income s tatement wo uld probably be the most useful for potential investors to examine because it indicates the company’s profitability for the period. However, this statement should not be examined without also reviewin g the Statement of Cash Flows. Investors would want info rmation about the cash inflows and outflows from operating, investing, and financing activities so as to be able to make judgments about the ability of the firm to meet current obligations as well as determine what type of activities are providing the cash resources that allow the company to meet those obligations. 30. I could not justify inflating sales or net income, even if it meant that possible loss of jobs. Tim should have the accountant project earning s for the next several years with and without the purcha se of this piece of equipment. Tim should then take these projections to the bank with him when he goes to see the banker. Tim possibly does not want to appear at fault because of declining profits over the past years. 31. (a and b) Whitecott on has violated both principles of comparability and consistency with the third change in as many years. These principles make the financial statements more reliable to users, so changing methods of depreciation on a yearly basis might make financial statements unreliable. Hethcox has followed the principle of full disclosure. Even though the sales happened after the end of the most recent accounting cycle, the operation s of these divisions did have an impact on the information being presented currently. Still Gardening is appropriately applying the lower of cost or market rule (conservatism) for valuing inventory on the balance sheet. Mason has followed full disclosure of lease payments. This information should be disclosed to financial statement reade rs and would be of interest to current and potential investors and creditors. CASES 32. (a) (1) Interest income is separated fr om is income generated from non operating activities like inves ting and financing activities. Thus, interest income is liste d as a separate line item because it is not income generated from the principal activities (providing cruise services) of Carnival. (2) Carnival primarily provides a service, although the company does sell some products. For this reason, Carnival’s cost of goods sold would be a relatively small portion of its expenses. In fact, the company does not list cost of goods sold separately and do es not calculate Gross Profit. (3) Primary operating revenues are t icket sales for cruises, sales of sightseeing packages, sales of items to passengers, etc. (b) (1) Total Assets = $34,181 ,000,000 (2) A trademark is a symbol or sign used by a business to ide ntify its product or services. Trademarks distinguish a business’s services and products and have a considera ble intangible value. Trademarks are shown as asset s because they have the potential to produce future benefits. (3) Cost of PPE $32,540,000 ,000 Depreciation $5,901,000 ,000 (4) The historical cost principal dictates that most assets are shown on t he financial statements at their original cost. Use of historical cost as the valuation basis for assets stems from the fact that historical cost is more verifiable and less subject to estimation than current values. (5) Customer deposits represent money a customer gave Carnival for a fu ture cruise. Until Carnival provides the cruise service to its customer, the money that has been paid by the customer is unearned. Thus, an unearned revenue account is established and this account is classified as current l iability because Carnival owes the customer a cruise or a refund. (6) The current portion of long -term debt is shown in footnote 5 as $1,028,000,000. This amount represents the portion of long -term debt that comes due within the next accounting period. (7) Profits generated but not distributed to owners are shown in Retained Earnings. As of November 30, 2007, Carnival’s Retained Earnings was $12,921,000 ,000. During fiscal year 2007, Carnival paid out total dividends of $990,000,000. 33. (a) For ac counting information to be useful, it must possess a high degree of relevance by being timely and having feedback and/or predictive value. The information contained in Note 7 can help predict amounts that Carnival may owe in the future. Therefore, it is relevant. (b) Materiality refers to the relative importance of specific it ems of accounting information. An item is deemed material if its size (quantitative materiality) or informational content (qualitative materiality) is significant enough to influen ce a financ ial statement user’s decision. The contingent obligations for Carnival Corporation as of November 30, 2007 , amounted to $1.07 billion. This amount is significant and it c ould have adverse effects on the financial statements if recognized. (c) Objective 1 : Financial reports should provide information that is useful in making investing, lending, and other economic decisions. Objective 2 : Financial reports should provide information that is useful to decision - makers in predicting the future c ash flows of businesses and future cash dividends from those businesses. Objective 3 : Financial reports should provide information about the assets and liabilities of businesses and the transactions and other events that have resulted in changes in thos e assets and liabilities. (d) Objective 1 would be v iolated if Note 7 was omitted. Alt hough the amounts described in Note 7 are uncertain, they have the potential to increase expenses or decrease earnings. An investor or lender would want to know this i nformation before making a decision on investment or lending. Also, an investor may not be interested in investing in a company with a potential lawsuit related to The A merica ns with Disabilities Act. Objective 2 would also be violated if Note 7 was om itted. Without the information in Note 7, future cash flows might be overestimated . Objective 3 addresses c urrent and historical numbers. Because the amount s in Note 7 represent the future, Objective 3 would not be violated if Note 7 was omitted . CHAPTER 3 SOLUTIONS TO END OF CHAPTER MATERIAL QUESTIONS 1. Assets Land and Equipment Liabilities Accounts Payable and Unearned Revenue Stockholders’ Equity Common Stock and Retained Earnings 2. The sale of stock in an entity, recording of net income (o r net loss) for a period, and dividends declared for company stockholders affect stockholders’ equity . Example 1: Issued 5,000 shares of XYZ Co.’s $1 par value common stock. Checks totaling $5 ,000 were received from stockholders. Example 2: A dividend of $1,000 was declared and paid by the corporation . 3. Common types of source documents include invoices, sales slips, legal contracts, checks, and purchase orders. Invoices – Purchase transaction details. Sales slips – Sale transaction detail. Legal cont ract – The terms and conditions of the agreement between parties. Checks – The amount paid, signature of drawer, and name of drawee. Purchase orders – The quantity and type of goods ordered. 4. The general journal records economic events in chronological order. Posting financial information from the general journal to the general ledger is very important because the information is then presented per account rather than per transaction (as is in the general journal ). Posting simplifies the representation of data and increases the efficiency of accounting transactions. 5. A trial balance is a statement listing the debit and credit account balances from the general ledger accounts. A trial balance’s purpose is to assure that the accounting system is “in ba lance” (total debits and total credits are equal) at the point in time at which the trial balance is prepared . The fact that a trial balance is “in balance” does not necessarily mean that all transacti ons have been recorded correctly. For example, if the debit or credit of a journal entry were posted to an incorrect account, the debit and credit columns of the trial balance would be equal although at least one of the accounts would be incorrec t. Additionally, if the wrong amount were recorded in the jour nal entry, the debit and credit columns of the trial balance would be equal although at least two accounts would be incorrect. 6. A deferred expense is actually an asset that has been created by a prepayment of an expense, such as insurance and property taxes. If a portion of the prepayment has been “used up ,” failure to adjust the deferred expense (prepaid asset) at the end of an accounting cycle will cause the balance in the asset account to be overstated and the balance in the expense account to be un derstated. 7. A deferred revenue is a liability because the organization has received cash in advance of the ear ning process. Examples of deferred revenues include unearned magazine subscriptions revenu es and unearned rental income. If the company earns a portion or all of the deferred revenue, failure to adjust the balance will result in liabilities that are overstated and revenues that are understated. 8. An accrued revenue is an asset because it represents a receivable that has resulted from revenue s earned, but not yet received. Examples of accrued revenues include Interest Recei vable and Accounts Receivable. If revenues are earned but not accrued, revenu es and assets are understated. The adjusting entry corrects th ese understatement s. 9. The net income or net loss for a period must be transferred from the temporary revenue and expense accounts to Retained Earnings (a balance sheet account). This process is necessary so that the balance sheet will be in balance after the temporary accounts are closed. 10. The Retained Earnings account is presented in the stockholders’ equity section of the balance sheet; it is also on the stat ement of stockholders’ equity. This account represents the earnings of the organization that have not been distributed in t he form of dividends to the stockholders. 11. Dividends are distributions to stockholders for their investment in the organization. Dividends are found on the Statement of Stockholder’ Equity as a re duction of retained earnings. Dividends will also be fo und on the balance sheet in current liabilities as Dividends Payable if those dividends have been declared but not paid. Divide nds are not considered expenses because they are not actual costs of operating a business. Instead, dividends are returns on inve stments to the business’ investors. 12. Permanent accounts are not closed at the end of the cycle and a re found on the balance sheet. Temporary accounts (or nominal) accounts are closed at the end of the accounting cycle . Two temporary accounts (revenues and expenses) are found on the income statement ; one temporary account (Dividends) is shown on the Statement of Retained Earnings. The terms permanent and temporary are appropriate because those terms reflect the degree of continuity of the accounts on the financial statements. Permanent accounts continue from period to period, while temporary accounts are reduced to zero at the end of one period so that completely new information can be recorded in those accounts in the next period. 13. Adjusting entri es are made at the end of each accounting cycle to bring all revenue and expense accounts up -to-date so that those accounts reflect the appropriate amounts of revenues earned and expenses incurred during that particular cycle. Closing entries are made at the end of each accounting cycle to bring all temporary accounts to zero balances, which enable the organization to start the next accounting cycle with a “fresh slate.” EXERCISES 14. (a) F A journal entry may affect as many accounts as necessary as long as the dollar amount of the debits and credits are equal . (b) F An “in balance” trial balance does not mean that the accounting records are free of error because a misstatement in recording may still exist. (c) T (d) F By not recording a transaction in its entirety, the debits and credits of the business will still be in balance; however, the amounts of certain account balances will be incorrect. (e) T (f) F The closing process starts with preparing closing entries. (g) T (h) T (i) T (j) F Only the temporary accounts of an organization begin the period with zero balances. (k) T (l) F Double -entry bookkeeping is used in countries around the world . 15. a. & b. Alcoa Honeywell Darden’s Restaurants A DR L CR X DR L CR A DR A DR Q CR A DR L CR X DR X DR Q CR R CR A DR A DR 16. (a) Purchase d $400 of supplies for cash. Paid $270 of interest expense in cash. Purchased $4,000 of equipment by signing a note payable . (b) Instead of increasing Equipment and Notes Payable each by $4,000, the bookkeeper would have decreased both accounts by $4,000. Therefore, both would ha ve been understated by $8,000. Assuming no other transactions in these accounts, Equipment would have had an abnormal credit balance of $4,000 and Notes Payable would have be en an abnormal debit balance of $4,000. (c) The trial balance would still have balanced because equality between debits and credits would have existed, but the trial balance would not have been accurate. 17. (a) Cash 24,000 Unearned Rent Revenue 24,000 Prepaid Advertising 6,000 Cash 6,000 (b) Prepaid Rent 24,000 Cash 24,000 Cash 6,000 Unea rned Advertising Revenue 6,000 (c) The first transaction increased assets (cash) by $24,000 The second transaction increased one ass et (prepaid advertising) by $6,000 and decreased another asset (cash) by $6,000 ; thus, there was no effect on total assets. 18. (a) Cash would be classified as a current asset and Accounts Payable would be classified as a current liability. (b) Assets h ave debit balances. Liabilities have credit balances. (c) Cash has a debit balance of $ 18,400 . Accounts payable has a credit balance of $5,200. Cash Accounts Payable 14,000 10,000 4,000 6,000 9,000 600 5,000 8,200 8,000 2,000 1,000 1,000 18,400 Balance Balance 5,200 (d) The debit to Cash represents an i ncrease to the company’s cash. It could have been a result of an $8,000 payment on account by one of the company’s customers or a n $8,000 cash sale. (e) The debit to Accounts Payable represents a reduction to accounts payable . It could have been a result of a $5,000 payment on account by the company or a return of $5,000 of merchandise to a supplier. 19. (a-c) Cash Office Supplies 12,400 840 420 420___ 6,750 1,260 6,350 2,658 9,722 Accounts Receivable Accounts Payable 9,300 14,200 6,750 7,560 2,550 6,350 ___ 15,410 Inven tory Utility Expense 6,100 0 7,560 ___ 2,658 ___ 13,660 2,658 (d) The purpose of posting journal entries to the ledger accounts is to help consolidate the information by accounts so as to aid in financial statement preparati on and to provide specific information on balances in particular accounts. 20. (a-b) The following accounts would likely need an adjusting entry: Property, Plant, and Equipment would necessitate the recording of Depreciation Expense and the increasing of Accumulated Depreciation . Unearned Rent Revenue would necessitate the recording of the revenue earned during the period by decreasing that account and increasing Rent Revenue. Prepaid Rent would necessitate the recording of the Rent Expense incurred for the period and the reduction of Prepaid Rent . Note s Payable would necessitate an adjusting entry to record Interest Expense and Interest Payable for the period . (c) The non -affected accounts (cash, common stock, land, and retained earnings ) are not adjusted because their balance s do not change simply by the passage of time. 21. (a) Current liabilities that may have been recorded during the adjusting entry process include accounts payable, accrued compensation, other accrued expenses and income taxes payable. (b) The $200,000,000 of long -term debt that was coming due in the upcoming year would have been transferred from a long -term debt account to a current liability. (c) Compensation Expense 46.4 M Accrued Compensation Payable 46.4 M 22. (a) Cash 5,000 Unearned Design Fees 5,000 (b) Accounts Receivable 5,000 Unearned Design Fees 5,000 Design Fee Revenue 10,000 23. (a) Cleaning Supplies 6,500 Cash 6,500 (b) Supply Expense 3,100 Cleaning Supplie s 3,100 Accounts Receivable 4,100,000 Fees Earned 4,100,000 (c) The revenue recognition principle would have been violated if the year -end adjusting entry had not been made. Net i ncome (or net loss ) for the current period would have been underst ated (or overstated ), while net income (or net loss ) for the following period would be overstated (or understated ). Revenue should be reported in the period in which it is earned rather than in the period in which it is collected (which represents the cash basis of accounting). (d) By not recording entries that involve revenues and expenses, companies ca n manipulate their net income. The omission of Harsha’s adjusting entry would have overstated assets and understated expenses, thereby increasing net inc ome. The omission of Silverman & Sachs ’ adjusting entry would have understated assets and revenues, thereby reducing net income. Companies might choose to omit entries to mislead the users of the financial statements. 24. (a) Total Assets = Cash + Equipme nt + Supplies + Land $36,000 = $5,000 + $10,400 + Supplies + $16,400 Supplies = $36,000 – $5,000 – $10,400 – $16,400 Supplies = $4,200 Total Assets = Total Liabilities + Owner’s Equity Total Liabilities + Owner’s Equity = $36,000 Total Liabili ties + Owner’s Equity = A/P + N/P + Owner ’s Equity $36,000 = A/P + $10,800 + $18,000 A/P = $36,000 – $10,800 – $18,000 ) A/P = $7,200 (b) Total Liabilities + Owner’s Equity = A/P + N/P + Owner ’s Equity $39,800 = A/P + $10,800 + $18,000 A/P = $39 ,800 – $10,800 – $18,000 A/P = $11,000 Total Assets = Total Liabilities + Owner’s Equity Total Assets = Cash + Equipment + Supplies + Land $39,800 = $5,000 + $10,400 + Supplies + $16,400 Supplies = $39,800 – $5,000 – $10,400 – $16,400 ) Supplie s = $8,000 (c) Debits Credits Cash $5,000 Supplies 4,200 Equipment 10,400 Land 16,400 Accounts Payable $ 7,200 Notes Payable 10,800 Owners’ Equity 18,000 Total $36,000 $36,000 25. (a) Sales Revenue 50,000 Income Summary 50,000 Income Summary 26,000 Selling Expenses 12,000 Income Taxes Expense 8,000 Utilities Expense 6,000 Incom e Summary 24,000 Retained Earnings 24,000 (b) The company earned $24,000. (c) Cash : Current Asset sectio n of the Balance Sheet Accounts Receivable : Current Asset section of the Balance Sheet Unearned Rental Revenue : Current Liability section of the Balance Sheet Accounts Payable : Current Liability section of the Balance Sheet Prepaid Rent : Current A sset section of the Balance Sheet