Chapter 4: Adjusting the accounts and preparing financial statements

Case study Q4.2 – decision making:

David (the shareholder/director) really does not understand much about accounting so
he assumed that all expenses should be accounted for as an expense when paid,
and therefore he could not understand when you, as his accountant, explained
that the insurance premium should be recorded as a prepaid expense.
Required
(a) Explain to David the necessity of making adjusting entries at the end of an
accounting period. Include in your discussion some of the accounting concepts
involved and why they are important.
(b) What would have been the effect on profit if these adjusting entries had not been
made, and would the reports have been useful for decision making without the
necessary adjustments?

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Solutions Manual to accompany Accounting 11e by Hoggett et al. Not for distribution in full. Instructors may
post selected solutions for questions assigned as homework to their LMS

Case study Q4.2 – suggested answer (a):

When we use the accounting period concept, we artificially divide the life of a business into
periods such as one year for external reporting purposes, or one month for internal
reporting purposes. That allows us to produce useful reports for that period, which
allow the users thereof to assess the performance of the business, make comparisons
against prior periods, or from a management perspective, determine what needs
attention for the business to be able to enhance performance or achieve budgets.

Users of these financial reports want the information contained in the reports to be relevant
as they will be making decisions based on that information. Other important concepts
involved in the preparation of those financial reports are materiality (the omission of
material information could affect users decisions), full disclosure (non-disclosure of
an event affecting the business could affect users decisions), going concern (users
assume the business will continue indefinitely: if that is not the case then the values
shown in the statement of financial position could be misleading), and comparability
(if financial reports are not prepared the same way from one period to the next they
may no longer be useful for comparison of performance over time).

To produce financial statements that meet these criteria, and using the accrual basis of
accounting, we endeavour to match the income earned in one period with the
expenses incurred in producing that income in the same period. In order to achieve
this, adjusting entries are required at the end of an accounting period.

Some expenses paid in one period may not have actually expired (been consumed or used
up) in that period, as is the case for insurance premiums that are usually for a one year
period and will therefore expire month by month over that period. A major item that
will be consumed over a very long period of time is plant and equipment. In this
regard, depreciation expense records the portion of the plant and equipment that is
consumed in that period.

There may also be some expenses that should be included in that accounting period, but the
company has not yet received the bill from the provider. In order to include all
relevant data in that period these expenses can be estimated, or apportioned if the bill
has arrived prior to the completion of the financial reports.

Some costs, such as cost of sales/ services, have a direct relationship to the revenue earned.
Others, such as insurance, have an indirect relationship based on the concept of costs
involved in running the business for that period. All revenue and expenses relevant
for that accounting period must be included in order to produce reports that are useful
for the decision making purposes of users.

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Solutions Manual to accompany Accounting 11e by Hoggett et al. Not for distribution in full. Instructors may
post selected solutions for questions assigned as homework to their LMS

Exercise 4.2

Cash versus accrual basis of accounting

At the end of the first year of operations, Arch Etec, owner of Architect Designs,
engaged you to prepare yearly financial statements for the year ended 30 June 2021, on
both the cash basis and the accrual basis. The following data are a summary of selected
transactions that occurred during the year. Ignore GST.

1. Fees of $175 000 were collected for services provided during the year.
2. There were $9 000 in receivables at 30 June 2021 for services performed on credit.
3. Cash payments of $124 000 were made for salaries, rent, insurance and other
expenses incurred during the year.
4. Salaries owing but not yet paid amount to $4000.
5. On 15 June 2021, a client paid $3 000 in advance for services to be rendered during
the next financial year.
6. Expenses of $5 000 were prepaid (not included in the $124 000) at 30 June.

Required
(a) Calculate profit under both the cash basis and the accrual basis.
(b) Indicate how the following items would be reported in the business’s balance sheet
under the accrual basis:
(i) the $9 000 receivables
(ii) the unpaid salaries of $4 000
(iii) the $3 000 advance received on 15 June
(iv) the cash payment of $5 000 for prepaid expenses.
(LO1)

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Solutions Manual to accompany Accounting 11e by Hoggett et al. Not for distribution in full. Instructors may
post selected solutions for questions assigned as homework to their LMS

(a) Note that expenses and income are recorded excluding GST.

ARCHITECT DESIGNS
(ignoring GST)

Cash basis Accrual

basis
Cash income (revenue) $175 000 $175 000
Revenue earned but not yet received 9 000
Revenue received in advance but not yet 3 000
earned
TOTAL INCOME (REVENUE) $178 000 $184 000
Less Expenses
Salaries, rent & insurance 124 000 124 000
Salaries owed but not yet paid 4 000
Expenses prepaid but not yet incurred 5 000
TOTAL EXPENSES $129 000 $128 000

PROFIT $49 000 $56 000

(b)
(i) Accounts receivable $9000 – current asset
(ii) Salaries payable $4000 – current liability
(iii) Unearned design fees $3000 – current liability

© John Wiley & Sons Australia, Ltd 2021

Solutions Manual to accompany Accounting 11e by Hoggett et al. Not for distribution in full. Instructors may
post selected solutions for questions assigned as homework to their LMS

Problem 4.22

Preparing a worksheet

Non-GST version

Water Sports Hire runs a business on the Murray River hiring out water sports
equipment to holiday makers, tour operators and for corporate training sessions. The
unadjusted trial balance of Water Sports i Hire is shown below (ignore GST).

The following additional information is available at the end of June.

1. Repairs on a paddle board done in June for $1870 have not yet been paid for or
recorded. An invoice has been issued by the repairer.
2. Expired insurance amounted to $11 000.
3. Depreciation on the water sports equipment for 1 year is $28 500. Depreciation on
the office equipment is $1320.
4. Salaries earned but not paid amounted to $3780.
5. The balance in the Unearned Rental Revenue account includes $560 received for
services rendered on 27 June.
6. The June telephone costs of $600 have not been paid for or recorded at 30 June 2022.

© John Wiley & Sons Australia, Ltd 2021

Solutions Manual to accompany Accounting 11e by Hoggett et al. Not for distribution in full. Instructors may
post selected solutions for questions assigned as homework to their LMS

A tax invoice has been received.

7. Accrued interest on the loan payable is $7800.

Required
(a) Prepare a 10-column worksheet for the year ended 30 June 2022. (LO6)

© John Wiley & Sons Australia, Ltd 2021

Solutions Manual to accompany Accounting 11e by Hoggett et al. Not for distribution in full. Instructors may post selected solutions for questions assigned as
homework to their LMS

(a)
WATER SPORTS HIRE
Worksheet
for the year ended 30 June 2022

Unadjusted trial balance Adjustments Adjusted trial balance Income Statement Balance Sheet
Account Title Debit Credit Debit Credit Debit Credit Debit Credit Debit Credit
Cash at Bank 19 690 19 690 19 690
Accounts Receivable 15 200 15 200 15 200
Prepaid Insurance 12 500 (b) 11 000 1 500 1 500
Water Sports Equipment 267 300 267 300 267 300
Accum. Depr. Water Sports Equip. 105 600 (c) 28 500 134 100 134 100
Office Equipment 6 930 6 930 6 930
Accum. Depr. Office Equip. 2 940 (c) 1 320 4 260 4 260
Accounts Payable 19 600 19 600 19 600
Loan Payable 82 500 82 500 82 500
Unearned Rental Revenue 2 770 (e) 560 2 210 2 210
W. Water, Capital 111 580 111 580 111 580
W. Water, Drawings 27 390 27 390 27 390
Rental Revenue 119 690 (e) 560 120 250 120 250
Salaries Expense 50 160 (d) 3 780 53 940 53 940
Rent Expense 8 680 8 680 8 680
Repairs/Maint. Expense 9 770 (a)1 870 11 640 11 640
Marine Supplies Expense 22 440 22 440 22 440
Telephone Expense 4 620 (f) 600 5 220 5 220
$444 680 $444 680
Repairs/Maint. Exp. Payable (a) 1 870 1 870 1 870
Insurance Expense (b) 11 000 11 000 11 000
Depr. Exp. – Water Sports Equip. (c) 28 500 28 500 28 500
Depr. Exp. – Off. Equip. (c) 1 320 1 320 1 320
Salaries Payable (d) 3 780 3 780 3 780
Telephone Expense Payable (f) 600 600 600
Interest Payable (g) 7 800 7 800 7 800
Interest Expense (g) 7 800 7 800 7 800
55 430 55 430 488 550 488 550 150 540 120 250 338 010 368 300
Loss for the year 30 290 30 290
150 540 150 540 368 300 368 300

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