Financial Reporting and Analysis Chapter 2 Solutions Accrual Accounting and Income Determination Exercises

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1 Financial Reporting and Analysis Chapter 2 Solutions Accrual Accounting and Income Determination Exercises Exercises E2-1. Determining accrual and cash basis revenue Since the subscription begins with the first issue of 2002, no revenue can be recognized in 2001 on an accrual basis. No product or service has been exchanged between Gee Company and its customers. Therefore, no subscription revenue has been earned. On a cash basis, Gee would recognize the full amount of cash received of $36,000 as revenue in E2-2. Determining unearned subscription revenue Since subscription revenue is not earned until the customer has received the video, unearned subscription revenue should be equal to the amount of subscriptions sold but not yet expired. Sold in 2001/Expiring in 2002 $200,000 Sold in 2001/Expiring in ,000 Sold in 2000*/Expiring in ,000 Unearned subscription revenue $465,000 *(The subscriptions sold in 2000 that did not expire in 2000 or in 2001 must be carried over to 2002 where they will be earned and recognized.) E2-3. Converting from accrual to cash basis revenue Under the cash basis of income determination, the company would not regard its accounts receivable as revenue. To find cash basis revenue, we have to subtract the increase in accounts receivable from the revenue figure: Accrual basis revenue $1,750,000 + Beginning accounts receivable balance 375,000 - Ending accounts receivable balance (505,000) - Write-offs of accounts receivable (20,000) Cash basis revenue (cash collections on accounts receivable) $1,600,

2 Alternate Solution: Accounts Receivable Beginning balance $375,000 Sales on account 1,750,000 (Accrual basis revenue) $20,000 Accounts receivable write-off $1,600,000 Solve for: Cash collections Ending balance $505,000 $375,000 + $1,750,000 - $20,000 - = $505,000 = $1,600,000 E2-4. Converting from accrual to cash basis revenue To convert Tara s 2001 revenue from an accrual basis to a cash basis, we need to subtract the change in accounts receivable from the accrual basis revenue figure. Since no accounts were written off, we need not add back the allowance for doubtful accounts to the accounts receivable amounts. Accrual basis revenue $1,980,000 Beginning accounts receivable 415,000 Ending accounts receivable (550,000) Cash basis revenue $1,845,000 Accounts Receivable Beginning balance $415,000 Sales on account 1,980,000 (Accrual basis revenue) $1,845,000 Solve for: Cash collections Ending balance $550,000 $550,000 = $415,000 + $1,980,000 - = $1,845,000 E2-5. Converting from cash to accrual basis revenue To change Dr. Tracey s revenue from cash basis to an accrual basis, we have to add the earned but uncollected accounts receivable and subtract the beginning accounts receivable collected in 2001 but earned in We also need to subtract fees collected in 2001 but not earned until 2002 (unearned fees on 12/31/01): 2-2

3 Cash basis revenue $150,000 Beginning accounts receivable (12/31/00) (20,000) Ending accounts receivable (12/31/01) 35,000 Unearned fees on 12/31/01 (5,000) Accrual basis revenue $160,000 E2-6. Converting from cash to accrual basis revenue To transform Marr s 2001 cash basis revenue to an accrual basis, we need to subtract beginning rents receivable collected in the current year (2001) but earned in the previous year (2000) and add ending rents receivable (adjusted for write-offs) representing revenue earned in the current year that will not be collected until the next year (2001). Cash basis revenue $2,210,000 Beginning rents receivable (800,000) Ending rents receivable 1,060,000 Add back: Uncollectible rents written off in ,000 Accrual basis revenue $2,500,000 Below is an alternate solution to E2-6 using T-account analysis. Rents Receivable Beginning rents receivable $800,000 Solve for: Rentals on account (Accrual basis revenue) $2,500,000 Ending rents receivable $1,060,000 $800, $2,210,000 - $30,000 = $1,060,000 = $2,500,000 $30,000 Uncollectible rents written off $2,210,000 Rents collected (Cash basis revenue) E2-7. Converting from accrual to cash basis expense The total amount of insurance premiums paid in 2001 is equal to the insurance expense for 2001 less the beginning balance in prepaid insurance Insurance expense $875,000 Plus: Increase in prepaid insurance ($245,000 - $210,000) 35,000 Insurance premiums paid in 2001 $910,

4 Alternate Solution: The amount of premiums paid can be determined from a T-account analysis of prepaid insurance. Prepaid Insurance Beginning balance $210,000 Premiums paid $875,000 Estimated amounts charged to insurance expense Ending balance $245,000 $210, $875,000 = $245,000 = $875,000 + $245,000 - $210,000 = $910,000 E2-8. Determining accrued liabilities a) Store lease was paid at the beginning of each month so there is nothing to accrue for the 2001 lease. b) Net sales for 2001 were $450,000. $450,000, less the $250,000 of sales exempt from additional rent, is $200,000: $200,000 6% = $12,000 c) The portion of the electric bill that should be accrued for the 2001 balance sheet is 12/16/01 12/31/01 or half of the 30-day period:$850/2 = $425 d) The portion of the telephone bill that should be part of the 2001 balance sheet is only the December service portion, $250. Total accrued liabilities at December 31, 2001, are: Accrued rent payable $12,000 Accrued electrical bill obligation +425 Accrued telephone bill obligation +250 Total accrued liabilities $12,

5 E2-9. Determining gain (loss) from discontinued operations The amount of gain/loss from discontinued operations to be reported on the income statement is computed as follows: Munn Corp. Net Gain/Loss from Discontinued Operations Gain on sale of division $450,000 Division s loss (320,000) ($250,000) Net gain (loss) for division 130,000 (250,000) Income tax (savings) $130,000 30% = (39,000) ($250,000) 30% = 75,000 Net gain (loss) reported $91,000 ($175,000) E2-10. Determining cumulative effect of accounting change The net charge against income in the 2001 income statement would be the $500,000 of prepaid expense less the tax effect of the asset (40% of $500,000), $200,000. So the net charge against income due to the change in accounting principle is $300,000. E2-11. Determining cumulative effect of accounting change The cumulative effect of the accounting change on the 2001 income statement is the increase in inventory due to the change ($500,000) less the tax effect of this increase ($500,000 30% = $150,000). The cumulative effect is $350,

6 E2-12. Determining period vs. product costs Depreciation on office building Insurance expense for factory building Product liability insurance premium Transportation charges for raw materials Factory repairs and maintenance Rent for inventory warehouse Cost of raw materials Factory wages Salary to chief executive officer Depreciation on factory Bonus to factory workers Salary to marketing staff Administrative expenses Bad debt expense Advertising expense Research and development Warranty expense Electricity of plant Period Product Matched with sale as inventory cost Matched with sale directly The answers to most items are straightforward. However, there are some subjective calls. For instance, rent for inventory warehousing can be argued to be product costs and included as part of inventory costs. However, many companies expense this cost as a period expense because of materiality considerations. Some of the product costs are expensed as part of the inventory costs (e.g., cost of raw materials, factory wages, and transportation and transit insurance for inventory purchased), while others are expensed directly in the period in which the products are sold (e.g., bad debt expense and warranty expense). 2-6

7 E2-13. Cash versus accrual analysis To report Kelly Plumbing Supply's revenues on an accrual basis, we need to subtract the accounts receivable collected in December but earned in November, and add the sales on account made during December, to the cash received from customers during December To report Kelly Plumbing's expenses on an accrual basis, we have to subtract the cash paid to suppliers in December for inventory purchased and used in November, and add inventory that was purchased in November and used in December, to the cash paid to suppliers for inventory during December Cash received from customers during December 2001 $387,000 Cash received in December for November accounts receivable (139,000) December sales made on account 141,000 Accrual basis revenues $ 389,000 Cash paid to suppliers for inventory during December 2001 $131,000 Payments for inventory purchased and used in November (19,000) Inventory purchased in November but used in December 39,000 Accrual basis expenses $ 151,000 Accrual basis revenues $389,000 Less: Accrual basis expenses (151,000) Gross profit for the month of December $ 238,

8 E2-14. Accrual basis revenue recognition To report the accrual-based revenue for the month of July, we must analyze the change in the Accounts receivable and Unearned revenue accounts. Unearned revenue June 30 $5,000 Less: Balance at July 31 ( 3,000 ) Change in account $ 2,000 Since the balance in Unearned revenue decreased, we know that the change of $2,000 represents unearned revenue that was earned during the month of July. Accounts receivable at June 30 $30,000 Less: Balance at July 31 ( 29,000 ) Change in account$ $ 1,000 Since the balance in Accounts receivable decreased, we know that the change of $1,000 means that more cash was collected on account (cash basis revenue) than was sold on account (accrual basis revenue). Therefore, if we start with cash collections and add unearned revenue that would be recognized in July and subtract the decrease in Accounts receivable we are able to determine the revenue that Runway should report in the month of July. Payments on account for July $73,000 Add: Unearned revenue earned in July 2,000 Less: Decrease in accounts receivable (1,000) Revenue for July $ 74,

9 Below is an alternative solution to E2-14 using T-account analysis. Beginning accounts receivable $30,000 Accounts receivable Solve for: Sales of mowing services on account (Accrual Basis Revenue) $72,000 Ending accounts receivable $29,000 $73,000 Payments received on account (Cash Basis Revenue) $30, $73,000 = $29,000 = $72,000 Unearned revenue Beginning unearned revenue $5,000 $2,000 Solve for: Unearned service revenue that was earned in July Ending unearned revenue $3,000 $5,000 - = $3,000 = $2,000 $72,000 + $2,000 = $74,

10 E2-15. Determining effect of omitting year-end adjusting entries OS = overstated US = understated NE = no effect Net Assets Liabilities Income Supplies Inventory Direction of effect OS NE OS Dollar amount of effect $9,000 1 $9,000 1 Expense not recorded = $12,000 - $3,000 Unearned Revenue Direction of effect NE OS US Dollar amount of effect $6,000 2 $6,000 2 Revenue not recorded = $6,000 from July 1, 1999 to December 31, 1999 Gasoline Expense Direction of effect NE OS US Dollar amount of effect $2,500 3 $2,500 3 Gasoline expense not recorded = $2,500 Interest Expense Direction of effect NE US OS Dollar amount of effect $4,500 4 $4,500 4 Interest expense for 9 months not accrued = $50, /12 = $4,500 Depreciation Expense Direction of effect OS NE OS Dollar amount of effect $10,000 5 $10,000 5 Depreciation expense not recorded = $30,000/3 = $10,

Financial Reporting and Analysis (7 th Ed.) Chapter 2 Solutions Accrual Accounting and Income Determination Exercises

Financial Reporting and Analysis (7 th Ed.) Chapter 2 Solutions Accrual Accounting and Income Determination Exercises Exercises E2-1. Distinguishing accrual-basis revenue from cash receipts (AICPA adapted)