DESCRIPTIONS OF PROBLEMS, CASES, AND INTERNET ASSIGNMENT Below are brief descriptions of each problem, case, and Internet assignment. These descriptions are accompanied by the estimated time (in minutes) required for completion and by a difficulty rating. The time estimates assume use of the partially filled-in working papers.
Problems 4–1 Florida Palms Country Club
Students are required to make end-of-period adjusting entries and identify the type of each adjusting entry made. They must also distinguish between an asset’s fair market value and its net book value.
20 Easy
4–2 Enchanted Forest Students are required to make end-of-period adjusting entries, identify the type of each adjusting entry made, and analyze the effect of each adjustment on the income statement and balance sheet. In addition, they must compute annual interest expense and determine an asset’s net book value.
40 Medium
4–3 Gunflint Adventures Given selected account balances from an adjusted trial balance and other related data, students are required to answer questions about the adjusted amounts and to reconstruct the adjusting entries.
25 Strong
4–4 Campus Theater Students are required to make end-of-period adjusting entries, and draw conclusions related to depreciation estimates and profitability.
30 Medium
4–5 Ken Hensley Enterprises, Inc. Students are required to make end-of-period adjusting entries, compute income, and analyze changes in various accounts.
50 Strong
4-6 Stillmore Investigations Students are required to make end-of-period adjusting entries, prepare an adjusted trial balance, compute income, and analyze changes in various accounts.
60 Strong
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4–7 Coyne Corporation Students are to analyze and interpret the effects of various errors on elements of the financial statements.
20 Strong
Cases 4–1 Property Management Professionals
Students are to evaluate several situations and explain whether a year-end adjusting entry is needed. Students must also explain the effects of any required adjustments.
30 Medium
4–2 Materiality and Avis Rent-a-Car Discusses the concept of materiality. The purchase of automobiles by Avis for its rental fleet is used to illustrate how the cumulative effect of many immaterial transactions can become material.
25 Medium
Business Week Assignment 4–3 Business Week Assignment
Students are asked to account for a prepaid lease agreement of a private jet. They must also consider justifications for the extremely high cost of the lease.
15 Medium
Internet Assignment 4–1 Hershey Corporation
Students are asked to identify accounts in Hershey’s balance sheet that were most likely to have been involved in the company’s year-end adjusting entry process.
SUGGESTED ANSWERS TO DISCUSSION QUESTIONS 1. The purpose of making adjusting entries is to recognize certain revenue and expenses that are not
properly measured in the course of recording daily business transactions. These entries help achieve the goals of accrual accounting by recognizing revenue when it is earned and recognizing expenses when the related goods or services are used.
2. The only transactions that require end-of-period adjusting entries are those that affect the revenue or expenses of more than one accounting period. Adjusting entries then are needed to apportion the revenue or expense among the affected accounting periods.
3. All adjusting entries affect both an income statement account and a balance sheet account. Every adjusting entry involves the recognition of either revenue or expense. Revenue and expenses represent changes in owners’ equity, which appears in the balance sheet. However, owners’ equity cannot change by itself; there must also be a corresponding change in either assets or liabilities.
4. Making adjusting entries requires a better understanding of accrual accounting than does the record-ing of routine business transactions because there is no “external evidence” (such as bills or invoices) indicating the need for adjusting entries. Adjusting entries are necessary to reflect recorded costs that have expired and recorded revenue that has been earned or to recognize previously unrecorded busi-ness activities. Thus, the need for adjusting entries is determined by the accountant’s understanding of the concepts of accrual accounting, not by external source documents.
5. Under accrual accounting, an expense is defined as the cost of goods and services used in the effort to generate revenue. Thus, an expense is incurred when the related goods and services are used, not when the expense is paid. A 12-month insurance policy represents insurance coverage that is used up over a 12-month period. The cost of such a policy should be debited to an asset account and gradually recognized as an expense over the 12 months that the policy is in force.
6. Accrual accounting requires that revenue be recognized in the accounting records when it is earned. If revenue has been earned, but not yet recorded in the accounts, an adjusting entry should be made to include this revenue in the income of the current period. This entry will credit a revenue account; as the revenue has not yet been collected, the debit will be to an account receivable.
7. The term, unearned revenue, describes amounts that have been collected from customers in advance and that have not yet been earned. As the company has an obligation to render services to these customers or to refund their advance payments, unearned revenue appears in the liability section of the balance sheet. As services are performed for these customers, the liability is reduced. Therefore, an adjusting entry is made transferring the balance of the unearned revenue account into a revenue account.
To record salaries expense and related liability to employees for the last four days of the year (4⁄5 × $20,000 = $16,000).
9. In the income statement, the Insurance Expense account will be understated; hence total expenses will be understated, and net income will be overstated. In the balance sheet, the asset account, Unexpired Insurance, will be overstated, as will the amount for total assets. Offsetting this overstatement of assets will be an overstatement of retained earnings; hence owners’ equity will be overstated.
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10. Materiality refers to the relative importance of an item or an event to the users of financial statements.
An item is “material” if knowledge of it might reasonably influence the decisions of financial statement users.
If an item is not material, by definition it is not relevant to decision makers. Therefore, the item may be treated in the most convenient and economical manner by the preparer of the financial statements. Thus, the concept of materiality permits departures from other generally accepted accounting principles in accounting for items that are not material.
11. The concept of materiality permits accountants to handle items that are unlikely to influence the decisions of users of the accounting information in the most convenient and economical manner. Charging the costs of low-priced and short-lived assets immediately to an expense is not likely to affect the decisions of users of the financial statements. On the other hand, accounting for these items as assets and recording periodic depreciation would require time, effort, and cost. Thus, low-priced and short-lived assets are routinely charged to an expense, because charging them to asset accounts simply is “not worth the bother.”
Ex 4–1 a. Book value b. Materiality c. Matching principle d. Unrecorded revenue e. Adjusting entries f. Unearned revenue g. Prepaid expenses h. None (This is an example of “depreciation expense.”)
Ex. 4–2 Income Statement Balance Sheet Adjusting
Entry
Revenue
−
Expenses =Net
Income
Assets =
Liabilities +Owners’Equity
a NE I D D NE D b NE I D NE I D c I NE I I NE I d NE I D NE I D e NE I D D NE D f I NE I NE D I
Ex. 4–3 a. Rent Expense ...................................................................................... 240,000 Prepaid Rent ........................................................................... 240,000 To record rent expense for May ($1,200,000 ÷ 5 months =
$240,000 per month).
b. Unearned Ticket Revenue ................................................................. 148,800 Ticket Revenue ....................................................................... 148,800 To record earning portion of season ticket revenue relating to
May home games.
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Ex. 4–4 a. Prepaid Advertising is reported in the balance sheet as an asset. Customer Deposits are reported in the balance sheet as liabilities.
b. Advertising Expense........................................................................... 18,000,000 Prepaid Advertising ............................................................... 18,000,000 To record the mailing of brochures costing $18 million to print. c. Customer Deposits ............................................................................. 90,000,000 Cruise Revenue....................................................................... 90,000,000 To record revenue earned for voyages completed. d. The adjusting entry that results in the most significant expense in the company’s income
statement is the recording of depreciation expense on its cruise ships. Note to the instructor: In a recent income statement the company reported depreciation
expense in excess of $300,000,000. Ex. 4–5 a. (1) Interest Expense........................................................................... 375 Interest Payable ............................................................... 375 $50,000 x 9% annual rate x 1/12 = $375.
(2) Accounts Receivable .................................................................... 10,000 Consulting Fees Earned .................................................. 10,000 To record ten days of unbilled consulting fees at $1,000 per
day. b. $2,250 ($50,000 x 9% x 6/12 = $2,250) c. $15,000 ($25,000 - $10,000 earned in December, 2005) Ex. 4–6 a. At the time cash is collected by American Airlines for advance ticket sales, the entire
amount is accounted for as unearned revenue. The liability created represents the deferral (or the postponement) of earned revenue until flight services are actually provided to passengers.
b. Airlines normally reduce the balance of this liability account by converting it topassenger revenue as flight services are provided. On some occasions, however, theliability may be reduced as a result of making cash refunds to customers due to cancellations.
c. Air Traffic Liability ............................................................................ 200,000 Passenger Revenue Earned ....................................................... 200,000 To record passenger revenue earned from advance ticket sales
Ex. 4–7 a. 1.Interest Expense ................................................................................ 1,200 Interest Payable...................................................................... 1,200 To record interest accrued on bank loan during December.
2.Depreciation Expense: Office Building ........................................... 1,100 Accumulated Depreciation: Office Building........................ 1,100 To record depreciation on office building ($330,000 ÷ 25 years ×
1⁄12 = $1,100).
3.Accounts Receivable ......................................................................... 64,000 Marketing Revenue Earned .................................................. 64,000 To record accrued Marketing revenue earned in December.
4.Insurance Expense ............................................................................ 150 Prepaid Insurance .................................................................. 150 To record insurance expense (1,800 ÷ 12 months = $150).
5.Unearned Revenue ............................................................................ 3,500 Marketing Revenue Earned .................................................. 3,500 To record portion of unearned revenue that had become earned
in December.
6.Salaries Expense................................................................................ 2,400 Salaries Payable...................................................................... 2,400 To record accrued salaries in December.
b. $62,650 ($64,000 + $3,500 − $1,200 − $1,100 − $150 − $2,400). Ex. 4–8 a. The total interest expense over the life of the note is $5,400 ($120,000 × .09 × 6⁄12 =
$5,400). The monthly interest expense is $900 ($5,400 ÷ 6 = $900).
b. The liability to the bank at December 31, 2005, is $121,800 (Principal, $120,000 + $1,800accrued interest).
c. 2005 Oct. 31 Cash.................................................................................... 120,000 Notes Payable ........................................................ 120,000 Obtain from bank six-month loan with interest at 9%
a year.
d. Dec. 31 Interest Expense................................................................ 900 Interest Payable .................................................... 900 To accrue interest expense for December on note
payable ($120,000 × 9% × 1⁄12).
e. The liability to the bank at March 31, 2006, is $124,500, consisting of $120,000 principal plus $4,500 accrued interest for five months.
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Ex. 4–9 a. May 1 Cash.................................................................................... 300,000 Notes Payable ........................................................ 300,000 Obtained a three-month loan from National Bank at
12% interest per year.
May 31 Interest Expense................................................................ 3,000 Interest Payable .................................................... 3,000 To record interest expense for May on note payable to
National Bank ($300,000 × 12% × 1⁄12 = $3,000).
b. May 1 Prepaid Rent...................................................................... 180,000 Cash........................................................................ 180,000 Paid rent for six months at $30,000 per month.
May 31 Rent Expense..................................................................... 30,000 Prepaid Rent.......................................................... 30,000 To record rent expense for the month of May.
c. May 2 Cash.................................................................................... 910,000 Unearned Admissions Revenue ........................... 910,000 Sold season tickets to the 70-day racing season.
May 31 Unearned Admissions Revenue ....................................... 260,000 Admissions Revenue ............................................. 260,000 To record admissions revenue from the 20 racing days
in May ($910,000 × 20⁄70 = $260,000).
d. May 4 No entry required.
e. May 6 Prepaid Printing................................................................ 12,000 Cash........................................................................ 12,000 Printed racing forms for first 30 racing days.
May 31 Printing Expense............................................................... 8,000 Prepaid Printing.................................................... 8,000 To record printing expense for 20 racing days in May.
f. May 31 Concessions Receivable .................................................... 16,500 Concessions Revenue ............................................ 16,500 Earned 10% of refreshment sales of $165,000 during
Something to Consider: Effects of omission of May 31 adjusting entry for rent expense on May 31 financial
statements: Revenue Not affected Expenses Understated (by May’s rent of $30,000) Net Income Overstated (because May rent expense was not recognized) Assets Overstated (Prepaid Rent should be reduced by portion expired in
May) Liabilities Not affected Owners’ Equity
Overstated (because net income is overstated)
Ex. 4–10 a. Materiality refers to the relative importance of an item. An item is material if knowledge of it might reasonably influence the decisions of users of financial statements. If an itemis immaterial, by definition it is not relevant to decision makers.
Accountants must account for material items in the manner required by generallyaccepted accounting principles. However, immaterial items may be accounted for in themost convenient and economical manner.
b. Whether a specific dollar amount is “material” depends upon the (1) size of the amountand (2) nature of the item. In evaluating the size of a dollar amount, accountants consider the amount in relation to the size of the organization.
Based solely upon dollar amount, $2,500 is not material in relation to the financial statements of a large, publicly owned corporation. For a small business however, this amount could be material.
In addition to considering the size of a dollar amount, accountants must also considerthe nature of the item. The nature of an item may make the item “material” to users ofthe financial statements regardless of its dollar amount. Examples might include bribespaid to government officials, or theft of company assets or other illegal acts committedby management.
In summary, one cannot say whether $2,500 is a material amount. The answer dependsupon the related circumstances.
c. Two ways in which the concept of materiality may save time and effort for accountantsare:
1. Adjusting entries may be based upon estimated amounts if there is little or nopossibility that the use of an estimate will result in material error. For example, an adjusting entry to reflect the amount of supplies used may be based on an estimateof the cost of supplies remaining on hand.
2. Adjusting entries need not be made to accrue immaterial amounts of unrecordedexpenses or unrecorded revenue. For example, no adjusting entries normally aremade to record utility expense payable at year-end.
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Ex. 4–11 a. None (or Materiality). Accounting for immaterial items is not “wrong” or a “violation” ofgenerally accepted accounting principles; it is merely a waste of time. The bookkeeper is failing to take advantage of the concept of materiality, which permits charging im-material costs directly to expense, thus eliminating the need to record depreciation in laterperiods.
b. Matching.
c. Realization.
Ex. 4–12 Accounts likely to have required an adjusting entry are: 1. Investments 2. Accounts Receivable 3. Inventories 4. Prepaid Expenses 5. Deferred Income Taxes 6. Buildings 7. Machinery and Equipment 8. Trademarks 9. Accounts Payable 10. Accrued Liabilities 11. Income Taxes Payable 12. Deferred Compensation and Other Liabilities Note to the Instructor: The adjustments required for many of the accounts listed above
are discussed in subsequent chapters. Some are beyond the scope of an introductorycourse.
Green Fee Revenue 1 8 0 0To record green fees owed by the Tampa Univ. golf team.
(3)31 Unearned Membership Dues 1 0 6 0 0 0
Membership Dues Earned 1 0 6 0 0 0To record the portion of annual membership dues earnedin December.
(4)31 Depreciation Expense: Carts 1 0 0 0
Accumulated Depreciation: Carts 1 0 0 0To record December depreciation expense ($180,000 ÷15 years x 1/12).
(5)31 Interest Expense 3 0 0
Interest Payable 3 0 0To record accrued interest expense in December ($45,000 × 8% × 1/12).
(6)31 Insurance Expense 6 5 0
Unexpired Insurance 6 5 0To record December insurance expense ($7,800 × 1/12).
(7)No adjusting entry required. Revenue is recognized whenit is earned. Entering into a contract does not constitutethe earning of revenue.
(8)31 Income Taxes Expense 1 9 0 0 0
Income Taxes Payable 1 9 0 0 0To record income taxes accrued in December.
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PROBLEM 4–1
FLORIDA PALMS COUNTRY CLUB (concluded) b.
1. Accruing unpaid expenses.
2. Accruing uncollected revenue.
3. Converting liabilities to revenue.
4. Converting assets to expenses.
5. Accruing unpaid expenses.
6. Converting assets to expenses.
7. No adjusting entry required.
8. Accruing unpaid expenses.
c. The clubhouse was built in 1925 and has been fully depreciated for financial accounting purposes.The net book value of an asset reported in the balance sheet does not reflect the asset’s fair market value. Likewise, depreciation expense reported in the income statement does not reflect a decline in fair market value, physical obsolescence, or wear-and-tear.
To record accrued interest revenue on CDs on December 31.
(2)31 Interest Expense 8 5
Interest Payable 8 5 To record accrued interest expense in December ($12,000 x 8.5% x 1/12).
(3)31 Depreciation Expense: Buildings 2 0 0 0
Accumulated Depreciation: Buildings 2 0 0 0To record December depreciation expense ($600,000 ÷ 25 years x 1/12).
(4)No adjusting entry required. Revenue is recognized whenit is earned. Entering into a contract does not constitutethe earning of revenue.
(5)31 Salary Expense 1 2 5 0
Salaries Payable 1 2 5 0To record accrued salary expense in December.
(6)31 Camper Revenue Receivable 2 4 0 0
Camper Revenue 2 4 0 0To record accrued camper revenue earned in December.
(7)31 Unearned Camper Revenue 9 0 0
Camper Revenue 9 0 0To record revenue earned from campers that paid in advance ($5,400 ÷ 6 months).
(8)31 Bus Rental Expense 1 0 0 0
Accounts Payable 1 0 0 0To record accrued bus rental expense in December($40 per day x 25 days).
(9)31 Income Taxes Expense 8 4 0 0
Income Taxes Payable 8 4 0 0To record income taxes accrued in December.
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PROBLEM 4–2ENCHANTED FOREST (concluded)
b.
1. Accruing uncollected revenue.
2. Accruing unpaid expenses.
3. Converting assets to expenses.
4. No adjusting entry required.
5. Accruing unpaid expenses.
6. Accruing uncollected revenue.
7. Converting liabilities to revenue.
8. Accruing unpaid expenses.
9. Accruing unpaid expenses.
c. Income Statement Balance Sheet
Adjustment
Revenue
−
Expenses =
Net Income
Assets =
Liabilities
+
Owners’Equity
1. I NE I I NE I 2. NE I D NE I D 3. NE I D D NE D 4. NE NE NE NE NE NE 5. NE I D NE I D 6. I NE I I NE I 7. I NE I NE D I 8. NE I D NE I D 9. NE I D NE I D
d. $340 ($12,000 x 8.5% x 4/12) e. Original cost of buildings ................................................................................. $600,000 Accumulated depreciation: buildings (prior to adjusting entry 3 in part
$310,000 December depreciation expense from part a ................................................. 2,000 Accumulated depreciation, buildings, 12/31 .................................................. (312,000) Net book value at December 31 ....................................................................... $288,000
a. (1) Age of airplane in months = accumulated depreciation ÷ monthly depreciation. Useful life is given as 20 years, or 240 months. Cost $240,000 ÷ 240 months = $1,000 monthly depreciation expense Accumulated depreciation $36,000 ÷ $1,000 monthly depreciation = 36 months.
(2) At June 30, two months of prepaid airport rent have been converted to expense (May and
June). Thus, four months of prepaid airport rent remain at June 30. Remaining prepaid amount $7,200 ÷ 4 months remaining = $1,800 per month.
(3) At June 30, five months of the original insurance policy have expired (February through
June). Thus, seven months of coverage remains unexpired at June 30. Remaining unexpired amount $3,500 ÷ 7 months remaining = $500 per month. $500 monthly cost x 12 months coverage = $6,000 paid on February 1.
b. (1) Eight months (bills received January through August). Utilities bills are recorded as
monthly bills are received. As of August 31, eight monthly bills should have been received. (2) Seven months (January through July). Depreciation expense is recorded only in month-end
adjusting entries. Thus, depreciation for August is not included in the August unadjusted trial balance.
(3) Twenty months ($14,000 ÷ $700 per month). c. Corporations must pay their income taxes in several installment payments throughout the year.
The balance in the Income Taxes Expense account represents the total amount of income taxes expense recognized since the beginning of the year. But Income Taxes Payable represents only the portion of this expense that has not yet been paid. In the example at hand, the $4,740 in income taxes payable probably represents only the income taxes expense accrued in July, as Campus Theater should have paid taxes accrued in the first two quarters by June 15.
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50 Minutes, Strong PROBLEM 4–5KEN HENSLEY ENTERPRISES, INC.
c. Monthly rent expense for the last two months of 2005 was $2,000 ($6,000 ÷ 3 months). The
$21,000 rent expense shown in the studio’s trial balance includes a $2,000 rent expense for November, which means that total rent expense for January through October was $19,000 ($21,000 - $2,000). The monthly rent expense in these months must have been $1,900 ($19,000 ÷ 10 months). Thus, it appears that the studio’s monthly rent increased by $100 (from $1,900 to $2,000) in November and December.
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PROBLEM 4–5KEN HENSLEY ENTERPRISES, INC. (concluded)
d. Insurance expense of $250 per month in the last 5 months of the year was $10 per month
more than the average monthly cost in the first 7 months of the year ($250 - $240). Insurance expense for 12 months ended December 31, 2005 $ 2 9 3 0
Less: Insurance expense in August through December @$250/month 1 2 5 0Insurance expense for January through July $ 1 6 8 0
÷ 7Average monthly insurance expense for January through July $ 2 4 0
months
e. Acumulated depreciation per trial balance $ 5 2 5 0 0
Add: December depreciation expense (adjusting entry 5) 1 5 0 0Accumulated depreciation at December 31, 2005 $ 5 4 0 0 0
÷ 1 5 0 0 per monthAge of equipment at December 31, 2005 3 6 months
f. Income Statement Balance Sheet
Adjustment
Revenue
−
Expenses =
Net Income
Assets =
Liabilities
+
Owners’Equity
1. I NE I I NE I 2. NE I D D NE D 3. NE I D D NE D 4. NE I D D NE D 5. NE I D D NE D 6. NE I D NE I D 7. I NE I NE D I 8. NE I D NE I D 9. NE I D NE I D
d. Rent expense of $300 per month in the last 3 months of the year was $275 per month
less than the average monthly cost in the first 9 months of the year ($575 - $300). Rent expense for 12 months ended December 31, 2005 $ 6 0 7 5
Less: Rent expense in October through December @$300/month 9 0 0Rent expense for January through September $ 5 1 7 5
÷ 9Average monthly rent expense for January through September $ 5 7 5
months
e. Insurance expense of $90 per month in the last 10 months of the year was $10 per month
less than the average monthly cost in the first 2 months of the year ($100 - $90). Insurance expense for 12 months ended December 31, 2005 $ 1 1 0 0
Less: Insurance expense in March through December @$90/month 9 0 0Insurance expense for January through February $ 2 0 0
÷ 2Average monthly insurance expense in January and February $ 1 0 0
months
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PROBLEM 4–6STILLMORE INVESTIGATIONS (concluded)
f. Accumulated depreciation per unadjusted trial balance $ 3 5 2 5 0
Add: December depreciation expense (adjusting entry 4) 7 5 0Accumulated depreciation at December 31, 2005 $ 3 6 0 0 0
÷ 7 5 0Age of equipment at December 31, 2005 4 8 months
per month
g. Income Statement Balance Sheet
Adjustment
Revenue
−
Expenses =
Net Income
Assets =
Liabilities
+
Owners’Equity
1. I NE I I NE I 2. I NE I NE D I 3. NE I D D NE D 4. NE I D D NE D 5. NE I D D NE D 6. NE I D D NE D 7. NE I D NE I D 8. NE I D NE I D 9. NE I D NE I D
a. Recorded a dividend as an expense reported in the income statement.
NE O U NE NE NE
b. Recorded the payment of an account payable as a debit to accounts payable and a credit to an expense account.
NE U O O NE O
c. Failed to record depreciation expense.
NE U O O NE O
d. Recorded the sale of capital stock as a debit to cash and a credit to retained earnings.
NE NE NE NE NE NE
e. Recorded the receipt of a customer deposit as a debit to cash and a credit to fees earned.
O NE O NE U O
f. Failed to record expired portion of an insurance policy.
NE U O O NE O
g. Failed to record accrued interest earned on an outstanding note receivable.
U NE U U NE U
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SOLUTIONS TO CASES
30 Minutes, Medium CASE 4–1PROPERTY MANAGEMENT PROFESSIONALS
a. No adjusting entry is needed, because although the revenue was collected in advance on Septem-
ber 1, it has all been earned prior to year-end. Thus, inclusion of the entire amount in revenue ofthe period is correct.
b. Three months’ revenue was collected in advance on December 1 and was credited to an unearnedrevenue account. At December 31, an adjusting entry is needed to recognize that one-third of this advance payment has now been earned. The effects of this adjusting entry will be to reduce aliability (unearned revenue) and increase revenue recognized as earned in the period. Of course,recognizing revenue also increases owners’ equity.
c. Management services rendered in December, but which are not billed to customers until thefollowing month, represent unrecorded revenue at year-end. An adjusting entry should be made to record this revenue, debiting Accounts Receivable and crediting appropriate revenue accounts. This entry will increase assets, revenue, and owners’ equity.
d. No adjusting entry is required, as none of the cost of this insurance policy expires in the currentyear.
e. An adjusting entry should be made to record depreciation expense on all equipment owned. The entry to record depreciation expense reduces assets, increases expenses, and reduces owners’equity.
f. Not recording salaries and wages expense until payroll dates is a common practice. However, salaries and wages actually represent expenses of the period in which employees render services,not the period in which they are paid. Thus, if the payroll date falls in another accounting period,an adjusting entry is needed to recognize as expense the cost of employees’ services during the current period. The effects of this entry are to recognize expense, which in turn decreases owners’equity, and also to recognize a liability for salaries (or wages) payable.
25 Minutes, Medium CASE 4–2THE CONCEPT OF MATERIALITY:
AVIS RENT-A-CAR
a. (1) An event or transaction is “material” when knowledge of the item reasonably may be expectedto influence the decisions of users of financial statements. One consideration is simply the sizeof the dollar amounts involved: what is “material” in relation to the operations of a smallbusiness may not be material in relation to the operations of a large corporation. In addition,the nature of the event plays a key role in determining whether or not knowledge of the event would influence decision makers.
There are no official rules determining what is—or is not—material. Thus, the “materiality” of specific events is a matter of professional judgment, left to the accountants preparingfinancial statements and also to the company’s auditors.
(2) In evaluating the “materiality” of an event or transaction, accountants should consider: (1) thedollar amounts involved, relative to the size of the business entity, and (2) the nature of thetransaction or event. The nature of an event, such as fraud by management, may be of interestto investors even though the dollar amounts are relatively small in relation to the company’soverall earnings and resources.
(3) The concept of materiality does mean that financial statements are not precise “down to the last dollar.” Such precision would be impossible to achieve in most large business organizations; further, such precision is not necessary. A “material” event is one that may influence thedecisions of informed users of financial statements. Thus, by definition, immaterial events do not influence decisions and, therefore, are irrelevant to the decision makers. The treatmentaccorded to immaterial events should not make financial statements less useful.
b. The concept of materiality would not permit Avis to charge the purchase of new automobiles forits rental fleet directly to expense. Although the cost of each individual car is immaterial to Avis, the cumulative cost of all cars purchased during the year is quite material.
Note to instructor: It is interesting to note that the effect of charging annual purchases of new rentalcars directly to expense might not have a material effect upon Avis’s income statement, as the cost ofnew cars purchased might be reasonably close to the depreciation expense that would be recognized annually had the cars been charged to an asset account. Thus, the overall effect on income might notbe “material.”
However, charging the purchases of new cars directly to expense would definitely cause a material distortion in the company’s balance sheet. One of its largest assets—its rental fleet—would simply not appear. Thus, both assets and owners’ equity would be understated by a material amount (the cost ofthe entire rental fleet).
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15 Minutes, Medium CASE 4–3
BUSINESS WEEK ASSIGNMENT
a. NetJets would account for the sale of Marquis Private Jet Cards by debiting Cash, and bycrediting a liability, Unearned Lease Revenue. As clients log hours of flight time, NetJetswould debit Unearned Lease Revenue, and credit Lease Revenue Earned (and report thisamount in its Income statement).
b. Clients of NetJets would account for the purchase of Marquis Private Jet Cards by debitingPrepaid Aircraft Leases, and by crediting Cash. As clients log flight time, they would debit Aircraft Lease Expense (an income statement account), and credit Prepaid Aircraft Leases.
c. There are numerous reasons why so many Fortune 500 companies may choose to purchaseMarquis Private Jet Cards for their executives rather than use the services of commercial airlines. They include:
• Convenience (NetJets flies 365 days a year, 24 hours a day, offering guaranteedavailability).
• Choice of aircraft (NetJets uses the best light, midsize and large cabin aircraft fromthe leading aircraft manufacturers, including Boeing, Cessna, Dassault Falcon,Gulfstream and Raytheon to meet the varying needs of its clients).
• Safety (NetJets has one of the best safety records in the airline industry).
• Comfort (flying in a private jet is far more comfortable than flying in commercial aircraft).
• Cost (it is often less costly to lease block of time on an aircraft than to actuallypurchase an aircraft for private use).
Accounts from Hershey’s balance sheet likely to have required an adjusting entry are:
1. Accounts Receivable–Trade
2. Inventories
3. Deferred Income Taxes
4. Prepaid Expenses
5. Accounts Payable
6. Accrued Liabilities
7. Accrued Income Taxes
8. Current portion of Long-Term Debt
9. Property, Plant, and Equipment
10. Other Intangibles
Note to the instructor: The adjustments required for several of the accounts listed above are discussed in subsequent chapters. Some are beyond the scope of an introductory course.
