CHAPTER 5THE ACCOUNTING CYCLE:REPORTING FINANCIAL RESULTSOVERVIEW OF BRIEF EXERCISES, EXERCISES, PROBLEMS AND CRITICALTHINKING CASESBriefExercisesB. Ex. 5.1B. Ex. 5.2B. Ex. 5.3B. Ex. 5.4B. Ex. 5.5B. Ex. 5.6B. Ex. 5.7B. Ex. 5.8B. Ex. 5.9B. Ex. .22.214.171.124TopicBalancing the accounting equationFinancial statement relationshipsClassifying balance sheetaccountsClosing temporary accountsClosing entries of profitable firmsClosing entries of unprofitablefirmsAfter-closing trial balanceProfitability and liquidityMeasuring interim revenueThe worksheetTopicAccounting terminologyFinancial statement preparationFinancial statement preparationClosing and after-closing trialbalanceClosing and after-closing trialbalanceReal World: Best Buy AdequateDisclosureClosing entries of profitable firmsClosing entries of unprofitablefirmsAdjusting versus closing entriesProfitability and liquiditymeasuresProfitability and liquiditymeasuresInterim resultsInterim resultsEffects of accounting errorsReal World: Home Depot, Inc. Usingan annual reportLearningObjectives1, 21, 21, on, analysisSkillsLearningObjectives1-71, 2, 61, 2, 62, 4, 5SkillsAnalysisAnalysisAnalysisAnalysis, communication2, 4, 5Analysis, communication3Analysis, communication2, 42, 4AnalysisAnalysis2, 46Analysis, communicationAnalysis61, 2, 71, 2, 72, 33, 6AnalysisAnalysisAnalysisAnalysisCommunication, analysis*Supplemental Topic, " The Worksheet." The McGraw-Hill Companies, Inc., 2012Overview
ProblemsSets A, B5.1 A,B5.2 A,B5.3 A,B5.4 A,B5.5 A,B5.6 A,B*5.7 A,B5.8 A,BTopicCorrecting classification errorsStatement preparation and closingprocess of a profitable firmStatement preparation and closingprocess of an unprofitable firmInterim financial statementsComprehensive problem combiningChapter 4 and Chapter 5Comprehensive problem combiningChapter 4 and Chapter 5Comprehensive problem combiningChapter 4 and Chapter 5Real World: Best Buy/The GapEvaluating profitability and liquidityCritical Thinking Cases5.1Adequate disclosure5.2Conflicts of interest(Ethics, fraud & corporate governance)5.3Sarbanes-Oxley Act: CEO and CFOpersonal certifications5.4Real World: Ford Motor CompanyAnnual report disclosures(Internet)LearningObjectives1, 2, 4, 61, 2, 4-6SkillsAnalysis, communicationAnalysis, communication1-4, 6Analysis, communication1, 2, 71–4, 6Analysis, communicationAnalysis, communication1–4, 6Analysis, communication8Analysis, communication6Analysis, communication3Analysis, communicationCommunication, judgment,analysis, researchAnalysis, judgment,communicationCommunication, technology,research133*Supplemental Topic, "The Worksheet." The McGraw-Hill Companies, Inc., 2012Overview (p.2)
DESCRIPTIONS OF PROBLEMS AND CRITICAL THINKING CASESBelow are brief descriptions of each problem and case. These descriptions are accompanied by theestimated time (in minutes) required for completion and by a difficulty rating. The time estimatesassume use of the partially filled-in working papers.Problems (Sets A and B)5.1 A,BParty Wagon, Inc./Strong Knot, Inc.Students are required to correct errors in a set of financial statements.Upon completion of the corrected financial statements, closing entriesand a brief financial analysis are required.20 Easy5.2 A,BLawn Pride, Inc./Garden WizardsStudents are required to prepare a set of financial statements for aprofitable company from an adjusted trial balance. Closing entries, anafter-closing trial balance, and a brief financial analysis are alsorequired.30 Medium5.3 A,BMystic Masters, Inc./Debit Doctors, Inc.Students are required to prepare a set of financial statements for anunprofitable company from an adjusted trial balance. Closing entries,an after-closing trial balance, and a brief financial analysis are alsorequired.45 Strong5.4 A,BGuardian Insurance Agency/Silver Real EstateInterim financial statements are required for a company that adjustsmonthly, but closes at year-end. This problem generates good classdiscussion.5.5 A,BSilver Lining, Inc./Next Job, Inc.This is a comprehensive problem that requires students to combineChapter 4 material with that of Chapter 5. An unadjusted trial balanceis presented. Students are required to prepare adjusting entries and anadjusted trial balance. From their adjusted trial balance they are askedto prepare a set of financial statements, closing entries, an after-closingtrial balance, and a brief financial analysis.70 Strong5.6 A,BBrushstroke Art Studio/Touchtone Talent AgencyThis is a comprehensive problem combining elements of Chapter 4 andChapter 5. It is similar in format to Problem 5.5 A,B.70 Strong*5.7 A,BInternet Consulting Service, Inc./Campus TheaterThis is a comprehensive problem that requires students to combineChapter 4 material with that of Chapter 5. From an unadjusted trialbalance, students are asked to complete a 10-column worksheet.50 Strong5.8 A,BBest Buy/The Gap, Inc.Information from an actual annual report is used to evaluateprofitability and solvency.*Supplemental Topic, " The Worksheet." The McGraw-Hill Companies, Inc., 2012Overview Desc.25 Easy15 Medium
Critical Thinking Cases5.1Adequate DisclosureStudents are asked to analyze five items that may (or may not) requiredisclosure in the notes accompanying the financial statements. Studentsmust defend their position.25 Strong5.2Working for the CompetitionEthics, Fraud & Corporate GovernanceThis is a group assignment focusing on the following issues: "Is itethical for a CPA to provide accounting services to companies thatcompete with each other?" Interviews are required.No time estimate5.3Sarbanes-Oxley Act and CEO/CFO CertificationsWorking in groups, students are required to discuss the meaning,purpose, and impact of CEO/CFO personal certifications required underthe Sarbanes-Oxley Act.5 Easy5.4Annual Report DisclosuresInternetStudents must identify and discuss topics disclosed in the company'sfinancial statements. This is a good problem to assign in conjunctionwith Case 5.1.15 Easy The McGraw-Hill Companies, Inc., 2012Desc. of Prob & Cases
SUGGESTED ANSWERS TO DISCUSSION QUESTIONS1. An annual report generally includes comparative financial statements, supporting informationabout the company’s financial position, its business operations, and a discussion bymanagement concerning the company’s future prospects. Before the annual report is issued,the financial statements must be audited by a firm of Certified Public Accountants (CPAs).Publicly owned companies must file their financial statements and detailed supportingschedules with the Securities and Exchange Commission (SEC).2. Retained earnings is that portion of stockholders’ equity created by earning income andretaining all or part of the resources created in the business. Income is a function of revenueless expenses. We have learned that cash is not always received at the exact time thatrevenue is earned, nor is cash necessarily disbursed at the exact time that an expense isincurred. Thus, the income retained by a company is not in the form of cash. Even if acompany’s income did equal its net cash inflow, the amount retained would not be kept inthe form of cash. As the company grew, the cash would be converted into property, plant,equipment, and other assets.3. The income statement, statement of retained earnings, and balance sheet are prepareddirectly from the amounts shown in the adjusted trial balance. The income statement reportsrevenue earned during the period less expenses incurred in generating that revenue. Whenrevenue exceeds expenses, net income is reported, and an increase in stockholders’ equityresults. When expenses exceed revenue, a net loss is reported, and a decrease instockholders’ equity results. The net income (or net loss) from the income statement is addedto the beginning Retained Earnings balance in the statement of retained earnings. Anydividends declared during the period are subtracted in arriving at the ending RetainedEarnings balance to be reported in the balance sheet at the end of the period.4. Items that may require disclosure include, but are not limited to: pending lawsuits, scheduledplant closings, certain governmental investigations, significant events occurring after thebalance sheet date but before the statements are issued, specific customers that account for alarge portion of the company’s business, names of stockholders that own large amounts ofthe company’s stock, any changes in accounting principles having a significant impact on thecompany’s financial position, and any unusual conflicts between the company and itsofficers. The McGraw-Hill Companies, Inc., 2012Q1-4
5. Temporary (or nominal) accounts include revenue, expenses, and dividend accounts. These arethe accounts involved in the closing process at the end of the year. Generally speaking, allincome statement accounts (and dividends reported in the statement of retained earnings) areconsidered temporary.6. Permanent (or real) accounts include assets, liability, and stockholders’ equity accounts. Theseaccounts are not involved in the closing process at the end of the year. Generally speaking, allaccounts reported in the balance sheet (and in the after-closing trial balance) are consideredpermanent.7. Dividends paid to stockholders are not considered an expense of the business and, therefore,are not taken into account in determining net income for the period. Since dividends are not anexpense, the Dividends account is not closed to the Income Summary account. Instead, it isclosed directly to the Retained Earnings account.8. After all revenue, expense, and dividend accounts have been closed, the only accounts thatremain are the permanent (or real) accounts appearing in the balance sheet. In comparison tothe adjusted trial balance, the after-closing trial balance contains only balance sheet accounts.Also, the Retained Earnings account is no longer reported at its beginning balance.9. A company can be both profitable and insolvent. For instance, the company’s sales might bemade only on account. If customers delay in paying what they owe, the average number ofdays that accounts receivable remain outstanding could be very high (say, 120 days). At thesame time, the company’s creditors may require payment at a much faster rate, say, 30 days.Thus even though this business might be profitable (i.e., its revenue exceed its expenses), itmay not be able to remain solvent if its accounts receivable fail to convert to cash in time tosettle its accounts payable.10. A company may close its accounts annually, but prepare financial reports monthly or quarterly.These monthly (or quarterly) statements are referred to as interim financial statements.General ledger accounts to be reported in the interim income statement require certaincomputations in order to determine their correct monthly or quarterly amounts. Computationsare not required to ascertain interim balance sheet amounts because the balance is alwaysbased on the account balances at the balance sheet date.11. Adequate disclosure means that financial statements should include whatever supplementalinformation is necessary for an intelligent user to interpret the statements properly.12. Unlike most other operating expenses, depreciation does not require regular periodic outlays ofcash. Depreciation is merely an estimate of that portion of a depreciable asset’s cost which is tobe matched against revenue earned during the current accounting period. The McGraw-Hill Companies, Inc., 2012Q4-12
13. Revenue, expense, and dividend accounts are called temporary accounts, or nominal accounts,because they accumulate the transactions of only one accounting period. At the end of theperiod, the changes in owners’ equity accumulated in these temporary accounts need to betransferred to the Retained Earnings account, and the temporary accounts need to have zerobalances in order to be ready to measure the revenue, expenses, and dividends of the nextaccounting period. The closing process serves these purposes. Revenue and expense accounts arefirst closed to the Income Summary account which, in turn, is closed to the Retained Earningsaccount. Any dividends declared during the period are then closed directly to the RetainedEarnings account.14. Return on equity is a measure of net income relative to a company's average stockholders' equitythroughout the year. Thus, it conveys the amount of income generated for every dollar of equitycapital. A high return on equity indicates that management efficiently used resources providedthrough owners' equity to generate income. A low return on equity indicates that managementwas not efficient in using resources provided through owners' equity to generate income.*15. A worksheet (or spreadsheet software): Provides a “scratch pad” for working out adjusting entries prior to actually entering theseitems in the accounts. Enables accountants to prepare interim financial statements without formally adjusting andclosing the accounts. Without affecting the account balances, provides both accountants and management with a“preview” of the effects of proposed entries upon the financial statements. *Supplemental Topic, " The Worksheet." The McGraw-Hill Companies, Inc., 2012Q13-15
SOLUTIONS TO BRIEF EXERCISESB. Ex. 5.1Decrease in assets during the year .Decrease in liabilities during the year .Increase in stockholders' equity during the year Less: New stock issued during the year Income for the year .Decrease to equity attributed to dividends .Capital stock (January 1, 2011) .Capital stock issued during the year Capital stock (December 31, 2011) .Add: Retained earnings (December 31, 2011) Total stockholders' equity (December 31, 2011) .B. Ex. 5.2 )200,00060,000260,00090,000350,000Note: The depreciation of the truck is included in the net incomewhich is included in the ending retained earnings given. Likewise,the dividend is also included in the ending retained earningsfigure given.B. Ex. 5.3 a.b.c.d.e.f.g.h.i.j.CACLCLNCA*SHELTLCLCANCACA* Accumulated depreciation is a contra asset classified in the non current assetsection of the balance sheet.B. Ex. 5.4 a.b.c.d.e.f.g.h.i.j.k.l.CNDCCNDNCNDC The McGraw-Hill Companies, Inc., 2012BE5.1-4
B. Ex. 5.5 Service Revenue Income Summary To close revenue to income summary.19,80019,800Income Summary . .Supplies Expense Rent Expense Depreciation Expense: Equipment Salaries Expense .Income Taxes Expense .To close expense accounts to income summary.18,700Income Summary .Retained Earnings To transfer net income to retained earnings.1,100Retained Earnings Dividends .To close dividends to retained earnings.6005253,6601,20012,7006151,100600B. Ex. 5.6 Consulting Fees Earned .Interest Revenue Income Summary .To close revenue to income summary.26,000300Income Summary .Insurance Expense .Rent Expense .Depreciation Expense: Office Equip. .Salaries Expense .To close expense accounts to income summary.34,700Retained Earnings .Income Summary .To transfer net loss to income summary.8,400Retained Earnings .Dividends .To close dividends to retained earnings.400 The McGraw-Hill Companies, Inc., 2012BE5.5-626,3001,90010,8005,60016,4008,400400
B. Ex. 5.7 a.b.c.d.e.f.g.h.i.j.k.l.B. Ex. 5.8CCDNCNNCDNCCa. Net Income ( 15,000) Total Revenue ( 60,000) .25%b. Net Income ( 15,000) Average Equity ( 37,500) .40%c.4-to-1Current Assets ( 16,000) Current Liab. ( 4,000)Computations:Total revenue Total expenses .Net income Stockholders' equity (January 1, 2011) Stockholders' equity (December 31, 2011) . 60,000(45,000)15,000 37,00038,00075,000 237,500Average stockholders' equity in 2011B. Ex. 5.9 a.April through September ( 450,000 - 140,000) . 310,000b.October through December ( 680,000 - 450,000). 230,000c.April through December ( 680,000 - 140,000) 540,000*B. Ex.5.10 a.Net income ( 540,000 - 410,000) 130,0001b.Income statement debits ( 380,000 - 130,000) . 250,000212The amount needed to make the columns of the balance sheet equal is netincome for the period.The credit column of the income statement represents total revenue whereasthe debit column amount represents total expenses. Thus, total revenue( 380,000 credit column amount) minus net income ( 130,000 computed in parta.), equals total expenses (i.e., the income statement debit column total).*Supplemental Topic, " The Worksheet." The McGraw-Hill Companies, Inc., 2012BE5.7-10
SOLUTIONS TO EXERCISESEx 5.1 a.Adequate disclosureb.Liquidityc.Nominal accountsd.Real accountse.After-closing trial balancef.Dividendsg.Closing entriesh.None (This is an example of a "correcting entry.")Ex. 5.2a.TUTORS FOR RENT, INC.Income StatementFor the Year Ended December 31, 2011Revenues:Tutoring revenue earnedExpenses:Salary expenseSupply expenseAdvertising expenseDepreciation expense: equipmentIncome before taxesIncome taxes expenseNet income 52,0001,2003001,000 96,00054,50041,50011,60029,900TUTORS FOR RENT, INC.Statement of Retained EarningsFor the Year Ended December 31, 2011Retained earnings (1/1/11)Add: Net IncomeLess: DividendsRetained earnings (12/31/11) The McGraw-Hill Companies, Inc., 2012E5.1,2 45,00029,9002,00072,900
Ex. 5.2 (concluded)TUTORS FOR RENT, INC.Balance SheetDecember 31, 2011AssetsCashAccounts receivableSuppliesEquipmentLess: Accumulated depreciation: equipmentTotal assets LiabilitiesAccounts payableIncome taxes payableTotal liabilities12,0005,000 Stockholders' EquityCapital stockRetained earningsTotal stockholders' equityTotal liabilities and stockholders' equity 91,1004,5003007,000102,9001,5003,5005,000 25,00072,90097,900 102,900b.The company appears to be extremely liquid. Cash and accounts receivable comprise 93%of total assets. Together, these highly liquid assets total 95,600, compared to only 5,000in liabilities coming due. In other words, the combined total of cash and accountsreceivable are 19 times the obligations coming due in the near future.c.The 45,000 credit Retained Earnings balance reported in the company’s adjusted trialbalance is its beginning balance. In order to have retained 45,000 in earnings, thecompany must have been profitable in the past. The McGraw-Hill Companies, Inc., 2012E5.2 (p.2)
Ex. 5.3a.WILDERNESS GUIDE SERVICES, INC.Income StatementFor the Year Ended December 31, 2011Revenues:Guide revenue earned Expenses:Salary expenseCamping supply expenseInsurance expenseDepreciation expense: equipmentInterest expenseNet Loss 87,5001,2009,6005,0001,700 102,000105,000(3,000)WILDERNESS GUIDE SERVICES, INC.Statement of Retained EarningsFor the Year Ended December 31, 2011Retained earnings (1/1/11)Less: Net lossLess: DividendsRetained earnings (12/31/11) The McGraw-Hill Companies, Inc., 2012E5.3 15,0003,0001,00011,000
Ex. 5.3 (Concluded)WILDERNESS GUIDE SERVICES, INC.Balance SheetDecember 31, 2011AssetsCashAccounts receivableCamping suppliesUnexpired insurance policiesEquipmentLess: Accumulated depreciation: equipmentTotal assets LiabilitiesNotes payable (due 4/1/12)Accounts payableTotal liabilitiesStockholders' EquityCapital stockRetained earningsTotal stockholders' equityTotal liabilities and stockholders' equity70,00060,000 0 25,00011,00036,000 63,500b.The company appears to be liquid. Cash and accounts receivable comprise 68% of thecompany’s total assets. These highly liquid assets total 43,200, in comparison to 27,500in liabilities coming due in the near f
Accounting terminology Financial statement preparation Financial statement relationships 1, 2 Classifying balance sheet 1, 2 Analysis accounts CHAPTER 5 THE ACCOUNTING CYCLE: REPORTING FINANCIAL RESULTS Topic Skills Learning Balancing the accounting equation 1, 2 OVERVIEW OF BRIEF EXERCISES, EXERCISES, PROBLEMS AND CRITICAL THINKING CASES Objectives Analysis Analysis Analysis, communication .
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