Learning Questions and Answers for Financial Accounting, Lesson 5.1 – Mastery Level

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1

As always, a list of carefully sequenced questions is provided. Read them. Think about each one. Provide your answer for as many as you can. From the guiding readings, you might be able to get many if not most. Then scroll down and read my answers. Take notes of important elements of the material, especially concerning any question that you did not fully know. Mark cards that you want to review later.

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Wait a couple of hours or a day and repeat the process. Read the questions, come up with your answers, and then read my answers. Fairly quickly, this information will be stored in your long-term memory, and you can make use of it as you analyze businesses and other organizations in order to make wise business decisions.

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(1) - Why are adjusting entries necessary in financial reporting? (2) - Adjusting entries are used to record the passage of time and its effect on account balances. When else are adjusting entries recorded? (3) - What do adjusting entries look like? (4) - When are adjusting entries made? (5) - What is an accrued expense?

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(6) - Accrued expenses could be recorded by an accounting system every day. This approach seems like a lot of effort unless that degree of accuracy is required for internal decision-making purposes. Normally, when are accrued expenses recorded? (7) - A company rents a building for $1,000 per day and makes a cash payment of $10,000 at the end of the tenth day. The company chooses to record this accrued expense each day as time passes. On the 8th day, the company prepares financial statements. What entry is made on each day? What entry is made on the 8th day in order to prepare the financial statements? What entry is made after the tenth day when payment is made?

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(8) - A company rents a building for $1,000 per day and makes a cash payment of $10,000 at the end of the tenth day. The company does not record this accrued expense each day. The daily information is not viewed as important. On the 8th day, the company prepares financial statements. What entry is made each day? What entry is made on the 8th day in order to prepare financial statements? What entry is made after the tenth day when payment is made? (9) - Insurance is one expense that is virtually always paid in advance. Assume on October 1, Year One, a company pays $24,000 for fire and other insurance for the following 12 months. What journal entry is made on that date and what adjusting entry is then made on December 31, Year One, assuming that no other adjusting entries had been made?

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(10) – In the previous question, assume when the payment was made that the accountant accidentally debited rent expense for $24,000 and credited cash for the same amount. The entry was never corrected. What adjusting entry should be made on December 31? (11) - A performance obligation is a promise to transfer goods and services to a customer. In accounting, revenue is recognized when the performance obligation is satisfied. How does the accountant identify a performance obligation? (12) - How can an accountant determine whether an agreement is one performance obligation or many?

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(13) - A company is hired to paint five buildings and the work is viewed as five separate performance obligations. The company will receive $10,000 for painting each building, but payment will not be made for several months. In December Year One, the first two jobs are finished. No journal entry is made. Is an adjusting entry necessary? (14) – On December 31, Year One, a company receives $10,000 in cash as a prepayment on the painting of a large building. The company debits cash for $10,000. What is the credit entry?

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(15) – What kind of account is deferred (or unearned) revenue? (16) – A company receives a cash payment of $10,000 in December of Year One for work to be done. The performance obligation is satisfied in February of Year Two. How is the recording made of these events? (17) – When are closing entries made?

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(18) – What kinds of accounts are closed out each period? (19) – What kinds of accounts are not closed out each period? (20) – Revenues, expenses, gains, losses, and dividend distributions are closed back to zero at the end of each fiscal period. Those balances cannot just disappear. Where do those monetary balances go?

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Stop and ask yourself whether there is anything in this material that you cannot do? I personally believe the answer is No. Adjusting entries and the rest of this chapter take practice but with work, they are within your abilities. With enough work, you could get all of these correct and make 100.

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The key to success with these learning questions and answers is to have the self-discipline necessary to do them several times. No one gets them all correct the first time but go over the questions and then the answers a few times and you should have all of this information under control.

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(1) - Why are adjusting entries necessary in financial reporting?

A company can have hundreds or thousands, or even millions, of transactions. As quickly as possible, these financial events are recorded by the company through journal entries. Many of the resulting balances will change gradually over time. For convenience, accounting systems often ignore these changes for as long as they can. There is little advantage in reporting daily changes of small amounts. Eventually, when financial statements are to be prepared, accountants study the account balances and prepare adjusting entries as needed. Most adjusting entries can be thought of as updating entries.

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(2) - Adjusting entries are used to record the passage of time and its effect on account balances. When else are adjusting entries recorded?

With so many transactions, companies sometimes make recording errors. Absolute perfection is rarely possible. Adjusting entries are used to fix any such mistakes that are made within the reporting process.

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(3) - What do adjusting entries look like?

Adjusting entries look identical to journal entries. Debit and credit balances are apparent. The labeling might be different to emphasize that they are not based on transactions but such labeling is not required.

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(4) - When are adjusting entries made?

They can be made at any time but organizations normally record adjusting entries as a preliminary step in preparing financial statements. This is often at the end of the fiscal year or possibly every month or every quarter.

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(5) - What is an accrued expense?

An accrued expense is one that grows gradually over time. Rent expense, salary expense, and interest expense are examples of accrued expenses because they can get a bit larger every day.

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(6) - Accrued expenses could be recorded by an accounting system every day. This approach seems like a lot of effort unless that degree of accuracy is required for internal decision-making purposes. Normally, when are accrued expenses recorded?

Most accrued expenses are recorded when cash is eventually paid or when financial statements are to be prepared. That is a simple approach that will meet the needs of most companies. Adjusting entries are used when balances are to be readied for the creation of financial statements.

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(7) - A company rents a building for $1,000 per day and makes a cash payment of $10,000 at the end of the tenth day. The company chooses to record this accrued expense each day as time passes. On the 8th day, the company prepares financial statements. What entry is made on each day? What entry is made on the 8th day in order to prepare the financial statements? What entry is made after the tenth day when payment is made?

Each day, the company will debit rent expense for $1,000 and credit rent payable for $1,000. No entry is made in preparation for producing financial statements because the expense and liability have already been recorded each day. On the tenth day, when payment is made, the company debits rent payable for $10,000 and credits cash for $10,000. That is a system that works.

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(8) - A company rents a building for $1,000 per day and makes a cash payment of $10,000 at the end of the tenth day. The company does not record this accrued expense each day. The daily information is not viewed as important. On the 8th day, the company prepares financial statements. What entry is made each day? What entry is made on the 8th day in order to prepare financial statements? What entry is made after the tenth day when payment is made?

The company makes no daily entries. Therefore, at the end of the 8th day, an adjusting entry is necessary to update the balances. The company debits rent expense for $8,000 and credits rent payable for the same amount. This adjustment brings the accounting records up-to-date for reporting purposes. After the tenth day, the cash payment is $10,000 but the rent payable balance remains at $8,000 based on the adjusting entry. Therefore, cash is credited $10,000, rent payable is debited $8,000 to remove the liability, and rent expense is debited for $2,000. The $2,000 expense is the recording for Day Nine and Day Ten.

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(9) - Insurance is one expense that is virtually always paid in advance. Assume on October 1, Year One, a company pays $24,000 for fire and other insurance for the following 12 months. What journal entry is made on that date and what adjusting entry is then made on December 31, Year One, assuming that no other adjusting entries had been made?

On October 1, Year One, it is likely that the company will debit prepaid insurance for $24,000 and credit cash for the same amount. Coverage is at a rate of $2,000 per month ($24,000/12 months). By December 31, Year One, three months have passed. The asset (prepaid insurance) should be reduced by $6,000 (to $18,000 for the remaining nine months) and the expense for those three months should be recognized. In a year-end adjusting entry, insurance expense is debited $6,000 and prepaid insurance is credited $6,000.

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(10) – In the previous question, assume when the payment was made that the accountant accidentally debited rent expense for $24,000 and credited cash for the same amount. The entry was never corrected. What adjusting entry should be made on December 31?

On December 31, three months have passed so the expense should be $6,000 ($2,000 per month times 3 months) and nine months are yet to pass so prepaid insurance should be $18,000 ($2,000 per month times 9 months). The company has recorded an expense of $24,000. To update those figures properly, the expense is reduced by $18,000 (as a credit) and the prepaid insurance is increased by $18,000 (as a debit). In this question and the previous one, the company must wind up with the same reported figures, but a different approach is taken to get there.

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(11) - A performance obligation is a promise to transfer goods and services to a customer. In accounting, revenue is recognized when the performance obligation is satisfied. How does the accountant identify a performance obligation?

A performance obligation can be identified when the required work encompasses just one complete job. For example, a company is hired to paint a five-story building. Painting the building is one job. That is one performance obligation. In other agreements, the work might well cover many separate performance obligations. For example, a company is hired to paint five houses located in five parts of the city. The painting of each house is likely to be considered a separate performance obligation unless the contract specifies that all must be painted or no payment will be made.

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(12) - How can an accountant determine whether an agreement is one performance obligation or many?

If the seller is entitled to payment after one part of the contract is complete, that job is probably a separate performance obligation. If you are hired to paint five houses and finish one, you are probably entitled to the payment for that one. That job is done. It is a separate performance obligation and revenue should be recognized when that one house is complete. If you are hired to paint a five-story building and you finish the first floor, you are probably not entitled to payment. Therefore, painting the building is one large performance obligation and not five small performance obligations.

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(13) - A company is hired to paint five buildings and the work is viewed as five separate performance obligations. The company will receive $10,000 for painting each building, but payment will not be made for several months. In December Year One, the first two jobs are finished. No journal entry is made. Is an adjusting entry necessary?

Assuming that painting each building is a separate performance obligation, the company has earned the revenue for the first two jobs. Because no money has yet been collected, the company will debit accounts receivable for $20,000 and credit sales revenue for $20,000. It is not the receipt of cash but the satisfaction of the performance obligation that leads to revenue recognition. That is the rule FASB established for U.S. GAAP and that is a rule that is often not well understood. Learning can help you understand the rules that must be followed.

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(14) – On December 31, Year One, a company receives $10,000 in cash as a prepayment on the painting of a large building. The company debits cash for $10,000. What is the credit entry?

The performance obligation is not yet satisfied so the company cannot record sales revenue. Instead, the company will record a credit of $10,000 to deferred (or unearned) revenue.

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(15) – What kind of account is deferred (or unearned) revenue?

Deferred revenue is reported as a liability. The company receives money before the performance obligation is satisfied. Therefore, the company owes the customer the remaining work or must return the payment.

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(16) – A company receives a cash payment of $10,000 in December of Year One for work to be done. The performance obligation is satisfied in February of Year Two. How is the recording made of these events?

When the money is received, cash is debited and deferred (or unearned) revenue is credited. Later, in Year Two, when the performance obligation is satisfied, the deferred revenue is removed with a debit and sales revenue is recognized with a credit. According to U.S. GAAP, revenue cannot be recognized until the performance obligation is satisfied (the work has been done).

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(17) – When are closing entries made

Closing entries are the final step in the accounting process at the end of each fiscal year.

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(18) – What kinds of accounts are closed out each period?

Revenues, expenses, gains, losses, and dividend distributions measure activities over a period of time (normally a year). At the end of that time, each of these accounts must be set back to zero so the activities for the following new year can be measured. The final entries made to return these balances to zero are known as closing entries. By entering these balances into retained earnings, the retained earnings balance is updated for this past year.

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(19) – What kinds of accounts are NOT closed out each period?

Assets, liabilities, and contributed capital measure amounts and not activities. Their balances are not set back to zero at the end of each year. For these accounts, the balance at the start of January 1 is the same as the ending balance on the previous December 31.

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(20) – Revenues, expenses, gains, losses, and dividend distributions are closed back to zero at the end of each fiscal period. Those balances cannot just disappear. Where do those monetary balances go?

The balance from each revenue, expense, gain, loss, and dividend distribution account is moved into the Retained Earnings T-account. Retained earnings reflects all previous net income amounts and dividend payments. The closing entries update that balance at the end of each year.

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If you can successfully answer all of these questions, move on to the next assignment. Until then, wait a bit and then run through all of these questions and answers again. Repetition is the key to doing well here.

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