Guided Readings for Financial Accounting, Lesson 5.1 – Mastery Level

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“Why Is Financial Information Adjusted Prior to the Production of Financial Statements?” The following flashcards were created to accompany the updated third edition of Chapter Five (Version 3.1) of Financial Accounting authored by Joe Hoyle, C. J. Skender, and Leah Kratz and published by FlatWorld.Copyright 2022 by Joe Hoyle

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Watch the opening video for Chapter Five of the textbook: Introduction to Chapter Five. This video follows up Chapter Four and its coverage of journal entries (which record the financial effect of transactions using a system of debits and credits). Chapter Five describes adjusting entries that are made to record account changes that occur because of the passage of time (or to fix mistakes).

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SUGGESTION: Accounting and business should be topics that extend well beyond the walls of a classroom. Thousands of exciting events occur each day in the world of business. The more you learn about the real world, the more you will understand the topics covered in class. Morning Brew is a daily email about current business news that was created by college students for college students. Learn what is happening each day. You can subscribe for free at: morningbrew.com

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Read the first section of Chapter Five (“The Need for Adjusting Entries”). As the title indicates, this section of Chapter Five explains the purpose and importance of the adjusting entries that are made within an accounting system. They record the effect on various account balances occurring purely because of the passage of time. The first section begins this coverage by looking at accrued expenses.

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This first section of Chapter Five is only about 4 pages, but it is vitally important to your understanding of financial reporting. Read those four pages and then go through these guided readings and let them help you learn this material. Mark any cards that you want to review prior to your Mastery Quiz for this section.

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(5Q1) – Why are adjusting entries necessary?

(5A1) – When accountants produce financial statements, they must ensure that all balances are presented fairly according to U.S. GAAP. Adjusting entries are made for that purpose. Many account balances are affected by the passage of time and must be updated periodically. Errors can exist in any account and need to be fixed. Adjusting entries also serve that purpose. All account balances are made ready for financial reporting by adjusting them to numbers that are presented fairly according to U.S. GAAP.

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(5Q2) – What is the difference between journal entries and adjusting entries?

(5A2) – Physically, no difference exists between journal entries and adjusting entries. They are both recorded in a company’s journal using debits and credits. Each figure is posted to the appropriate T-account in the ledger. The difference is in their purpose and timing.

--Journal entries record the effects of a transaction and are recorded soon after the event.

--Adjusting entries record the effects caused by the passage of time. They also correct errors. Adjusting entries are recorded as a preliminary step in preparing financial statements.

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(5Q3) – When are adjusting entries prepared and recorded?

(5A3) – Some companies with sophisticated computer systems prepare adjusting entries on a regular periodic basis such as weekly or monthly. At a minimum, adjusting entries must always be made as a necessary step in the production of financial statements. The goal of adjusting entries is to ensure that all reported balances are presented fairly according to U.S. GAAP.

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(5Q4) – Adjusting entries are often needed to record accrued expenses properly. What are accrued expenses?

(5A4) – As discussed in the previous chapter, accrued expenses are expenses that grow (often day by day) over time and are eventually paid at a later date. Salaries, interest, rent, and utilities are common examples of accrued expenses. The expense gets larger each day although payment is often delayed until a specific point in the future.

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(5Q5) – Employees of Haskins Co. earn a total salary of $1,000 per day. After 10 days, they are paid the $10,000 total that they are owed. What are the two most likely ways that the company can record this salary?

(5A5) – First Way: Company can record salary expense of $1,000 each day (debit) along with a salary payable (credit). When payment is made after ten days, salary payable is reduced $10,000 (debit) and cash is also reduced by that amount (credit). Second Way: Company records nothing each day. When payment is made, salary expense is increased $10,000 (debit) and cash is decreased by the same amount (credit).

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(5Q6) – Employees of Haskins Co. earn a salary of $1,000 per day. After 10 days, they are paid the $10,000 total they are owed. The company’s accounting system is programmed to record the earned amount of salary every day. After the first six days of the current time period, financial statements are to be prepared. What adjusting entry is needed?

(5A6) – The proper balances have already been entered into the accounting records each day. They are up-to-date and no adjusting entry is needed prior to producing financial statements. All reported balances are already presented fairly according to U.S. GAAP and no changes are necessary.

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(5Q7) – Employees of Haskins Co. earn a salary of $1,000 per day. After 10 days, they are paid the $10,000 total they are owed. The company makes no recording as the salary is earned each day. The accounting system is not programmed that way. After the first six days, financial statements are to be prepared. What adjusting entry is needed?

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(5A7) – The company must now record both the $6,000 expense that has been incurred and the liability owed for that amount. After the adjustment, the financial information will be presented fairly according to U.S. GAAP and financial statements can be prepared. The following adjusting entry is recorded.

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Work the first Test Yourself question in Section 5.1 of Chapter Five (“On Monday morning, a company hires…”). This question should help you gain understanding about the use of adjusting entries.

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Work the second Test Yourself question in Section 5.1 of Chapter Five (“A company owes its employees …”) and also the One Step Further question. The company has not recorded this accrued expense. Ask yourself what should have happened? What balances need to be adjusted at the end of the year? Do not continue until you understand the explanations for these two important questions.

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The following statement appears in the end of chapter material. The statement is TRUE. Explain why it is true. Statement: A company owes $9,000 in interest on a note payable at the end of the current year. The company fails to record this debt and the accountant accidentally overlooks the unrecorded balance so that no adjusting entry is made. As a result, reported net income will be overstated for the period.

ANSWER TO THE PREVIOUS TRUE-FALSE QUESTION: The statement is True. Interest expense of $9,000 should have been recorded this year. It was not recorded by the company as the balance grew. Unfortunately, it was not recorded as an adjusting entry. Hence, this interest expense has been omitted entirely. The reported balance is too low. If an expense (reported on the income statement) is too low, the resulting net income will be overstated (or too high). The answer is True.

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Read the second section of Chapter Five (“Preparing Various Adjusting Entries”). This section provides a complete overview of adjusting entries by analyzing prepaid expenses, accrued revenue, and unearned revenue. For example, at the beginning of this section, a $402.1 million asset is reported by General Mills titled “prepaid expenses and other current assets.” The textbook explores what information is conveyed to decision makers by an account with that title and balance.

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(5Q8) – On December 1, Year One, a company pays $9,000 cash to rent a building for the next nine months for $1,000 per month. What journal entry is normally made on December 1 for this transaction? What adjusting entry is made on December 31 so that financial statements can be prepared?

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(5A8) – This journal entry would be the standard entry to record the payment of cash for several months of rent.

Continued

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Continued from previous card

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Then, at the end of December, one month of rent must be reclassified from the asset account into an expense account. Time has passed. A future value of $1,000 has become a past value.

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(5Q9) – On December 1, Year One, a company pays $9,000 cash to rent a building for the next nine months for $1,000 per month. On December 1, for some reason, the accountant debited rent expense for $1,000 and credited cash for $1,000. What adjusting entry is made on December 31 so that financial statements can be prepared properly?

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(5A9) – In creating adjusting entries, the accountant takes the entry that was made and fixes (or updates) the balances so they will be presented fairly. Here, cash was credited by $1,000 but should have been reduced $9,000 so another $8,000 is recorded. Prepaid rent should be recorded as $8,000 for the remaining 8 months. Rent expense should be $1,000 which is already its balance so no change is needed.

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Revenue recognition rules were changed a few years ago by FASB. Now, when a company establishes a contractual agreement for the sale of a good or service with a customer, each separate performance obligation must be identified to indicate the work to be done. Revenue is recognized as each performance obligation is satisfied.

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(5Q10) - Assume a company works for a customer and charges $1,000 per day. Each day of work is viewed as a separate performance obligation. (For example, assume the company had to paint the porch on four houses in four locations—one to be painted each day.) Four days pass, the work is done, and the company collects $4,000. How could this be recorded?

(5A10) – First way: The company might record an increase (debit) of $1,000 to accounts receivable each day along with a $1,000 increase (credit) to revenue. A separate performance obligation is satisfied each day. Later, when the money is collected, cash is increased $4,000 (debit) and accounts receivable is reduced $4,000 (credit). Second way: The company could do nothing until the money is collected and then increase (debit) cash for $4,000 and increase (credit) revenue for $4,000. Both methods arrive at the same results.

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(5Q11) - Assume a company works for a customer for $1,000 per day. Each day is viewed as a separate performance obligation. Four days pass and the company is ready to prepare financial statements for the current year. No money has yet been paid. The company’s computer system has been recording this accrued revenue each day. What balances should be reported on the financial statements? What adjusting entry is recorded?

(5A11) – Here, the work done each day is viewed as a separate performance obligation. Because four days have passed and no money has been paid, the company should report accounts receivable of $4,000 on its balance sheet and sales revenue of $4,000 on its income statement. The company has recorded the amount earned each day. Those balances are already in the T-accounts and, thus, in the trial balance. No adjusting entry is needed. The balances are presented fairly according to U.S. GAAP.

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(5Q12) –Revenue recognition rules follow a defined path. Whenever a contractual agreement is established with a customer, each separate performance obligation must be identified. When a performance obligation is satisfied, revenue is recognized. Assume a company works for a customer for $1,000 per day. This one performance obligation will take 10 days of work to complete. Payment will then be made. After 3 days, financial statements are to be prepared. What is reported by the company?

(5A12) – The entire performance obligation has not yet been satisfied. Only three days of work out of the necessary ten have been completed. Revenue cannot be recognized. No cash has been received. Therefore, nothing needs to be recorded at this time. Unless a journal entry was made incorrectly, no adjusting entry is needed. The figures are already presented fairly according to U.S. GAAP. There is neither receivable nor revenue.

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Work the Test Yourself question in Section 5.2 of Chapter Five (“The Acme Company paints houses …”). In this practice problem, a company has painted a portion of a building and recognized the revenue. Is that correct? Has the company’s performance obligation been satisfied? Is the journal entry properly recorded? Make sure to read and think about the explanation.

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(5Q13) - Assume Ace Company will work for a customer for $1,000 per day. The one performance obligation will take 10 days to be satisfied. The entire $10,000 in cash is collected by Ace in advance. After the first 3 days, Ace will prepare its financial statements. What is reported by the company for this job and the work done to date?

(5A13) – When the money is collected, Ace Company should have increased (debit) cash by $10,000 and increased (credit) deferred (or unearned) revenue by $10,000. Deferred revenue is a liability. The company owes the promised work or the money will have to be returned to the customer. After the first three days, this one performance obligation has not yet been satisfied so no adjusting entry is needed. Ace Company should continue to report both the $10,000 cash and the $10,000 liability (deferred revenue) on its balance sheet.

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(5Q14) – Look at the adjusting entry presented in the textbook in Table 5.6. Deferred revenue is debited $600 and sales of services (a revenue account) is credited for the same amount. What is indicated by this adjusting entry?

(5A14) – Deferred (or unearned revenue) is a liability account. It is being debited which indicates a decrease. Sales of services is a revenue account. A credit indicates an increase in a revenue. In this entry, the deferred revenue is decreased while the revenue account is increased. This type of reclassification happens when a company collects money for work in advance and now a performance obligation is satisfied so that the deferred revenue is reported as earned.

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(5Q15) - Assume a company will work for a customer for $1,000 per day. This job will take 10 days but, because of the nature of the work, each day is viewed as a separate performance obligation. The entire $10,000 is collected in advance and the proper journal entry is made at that time. After 3 days, financial statements are to be prepared. No entry has been made since the cash was collected. What should the company now report?

(5A15) – When collected, the company should increase (debit) cash for $10,000 and increase (credit) deferred revenue for $10,000. Deferred revenue is a liability. The company owes the promised work or the money will have to be returned to the customer. Here, one performance obligation is satisfied each day. In preparing financial statements after three days, the company should report revenue of $3,000 and deferred revenue of $7,000 (for the next 7 days).

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(5Q16) - Assume a company will work for a customer for $1,000 per day. This job will take 10 days but, because of the nature of the work, each day is viewed as a separate performance obligation. The entire $10,000 is collected in advance and the proper journal entry is made at that time. After 3 days, financial statements are to be prepared. No entry has been made since the cash was collected. What adjusting entry is now needed?

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(5A16) – When collected, the company should have increased (debit) cash by $10,000 and increased (credit) deferred revenue by $10,000. Each day is deemed a separate performance obligation. Thus, $1,000 should be moved from deferred revenue to revenue for each day worked. Three days have passed but no reclassification has yet been made. This adjusting entry is needed.

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(5Q17) – On November 1, Year One, a company pays $10,000 to rent a building for the next 10 months. The proper entry was made at that time but no other entry has been made as of December 31 just prior to preparing financial statements. By how much is the company’s total reported assets misstated? By how much is the company’s reported net income misstated?

(5A17) – On November 1, prepaid rent was apparently increased (debit) by $10,000 and cash was decreased (credit) by $10,000. For 10 months, that is $1,000 in rent per month. After two months, the asset (prepaid rent) should be reduced (credit) $2,000 and rent expense increased (debit) $2,000. If that adjustment is omitted, the company’s reported assets are too high by $2,000 and expenses are too low by $2,000. Because expenses are too low, reported net income is too high by $2,000.

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(5Q18) – On September 1, Year One, a company pays $10,000 to rent a building for the next 10 months. The proper entry was made at that time. On December 31, the accountant made an adjusting entry that debited rent expense for $6,000 and credited prepaid rent for $6,000. By how much is the total of the company’s reported assets misstated? By how much is the company’s reported rent expense misstated?

(5A18) – Four months have passed so the adjustment should have been for $4,000 rather than $6,000. To fix mistakes like this, (1) identify what is reported, (2) determine what should be reported, and (3) measure the difference. A $6,000 expense was reported and should have been $4,000. Rent expense is $2,000 too high. Prepaid rent was reduced by $6,000 and should have been reduced by $4,000. It is reduced by too much and is $2,000 too low. That makes the reported asset total too low by the same $2,000.

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(5Q19) – Supplies are (a) used in a business but are not for resell and (b) have a life of one year or less. A company starts the year with supplies costing $900. Each month the company buys $1,000 in supplies and makes the proper entry. At the end of the year, the company makes a physical count and finds only $400 in supplies still being held. What adjusting entry is needed at the end of the year so that all balances are presented fairly according to U.S. GAAP?

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(5A19) – By the end of the year, the company has supplies recorded as $12,900. That is the beginning balance plus the 12 months of purchases. A count finds only $400 in supplies on hand. That means that $12,500 in supplies are gone ($12,900 less $400). The assumption is made that those supplies were used. The adjusting entry is:

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In the section of the textbook titled “Deferred (or Unearned) Revenue,” there is a link for a video titled “Learning to Prepare Adjusting Entries.” Watch that video and make certain that you can follow the explanation. If necessary watch the video twice to make sure you understand the process.

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