A.3. Accruals And Deferrals

1. Under a royalty agreement with another company, Wand Co. will pay royalties for the assignment of a patent for three years. The royalties paid should be reported as expense

In the period paid.

In the period incurred.

At the date the royalty agreement began.

At the date the royalty agreement expired.

Under accrual accounting, events that change an entity’s financial position are recorded in the period in which the events occur. This means revenues are recognized when earned rather than when cash is received, and expenses are recognized when incurred rather than when cash is paid. Therefore, when the royalties are paid, Wand should debit an asset account (prepaid royalties) rather than an expense account. The royalties paid should be reported as expense in the period incurred (by debiting royalty expense and crediting prepaid royalties).

Explanation

Under accrual accounting, events that change an entity’s financial position are recorded in the period in which the events occur. This means revenues are recognized when earned rather than when cash is received, and expenses are recognized when incurred rather than when cash is paid. Therefore, when the royalties are paid, Wand should debit an asset account (prepaid royalties) rather than an expense account. The royalties paid should be reported as expense in the period incurred (by debiting royalty expense and crediting prepaid royalties).

2. An analysis of Thrift Corp.'s unadjusted prepaid expense account at December 31, 2010, revealed the following: An opening balance of $1,500 for Thrift's comprehensive insurance policy. Thrift had paid an annual premium of $3,000 on July 1, 2009. A $3,200 annual insurance premium payment made July 1, 2010. A $2,000 advance rental payment for a warehouse Thrift leased for one year beginning January 1, 2011. In its December 31, 2010 balance sheet, what amount should Thrift report as prepaid expenses?

$5,200

$3,600

$2,000

$1,600

The opening balance in prepaid expenses ($1,500) results from a one-year insurance premium paid on 7/1/09. Since this policy would have expired by 6/30/10, no part of the $1,500 is included in 12/31/10 prepaid expenses. The insurance premium paid on 7/1/10 ($3,200) would be partially expired (6/12) by 12/31/10. The remainder (6/12 × $3,200 = $1,600) would be a prepaid expense at year-end. The entire advance rental payment ($2,000) is a prepaid expense at 12/31/10 because it applies to 2011. Therefore, total 12/31/10 prepaid expenses are $3,600. Prepaid insurance ($3,200 × 6/12) $1,600 Prepaid rent 2,000 Total prepaid expenses $3,600

Explanation

The opening balance in prepaid expenses ($1,500) results from a one-year insurance premium paid on 7/1/09. Since this policy would have expired by 6/30/10, no part of the $1,500 is included in 12/31/10 prepaid expenses. The insurance premium paid on 7/1/10 ($3,200) would be partially expired (6/12) by 12/31/10. The remainder (6/12 × $3,200 = $1,600) would be a prepaid expense at year-end. The entire advance rental payment ($2,000) is a prepaid expense at 12/31/10 because it applies to 2011. Therefore, total 12/31/10 prepaid expenses are $3,600. Prepaid insurance ($3,200 × 6/12) $1,600 Prepaid rent 2,000 Total prepaid expenses $3,600

3. Clark Co.'s advertising expense account had a balance of $146,000 at December 31, 2010, before any necessary year-end adjustment relating to the following: Included in the $146,000 is the $15,000 cost of printing catalogs for a sales promotional campaign in January 2011. Radio advertisements broadcast during December 2010 were billed to Clark on January 2, 2011. Clark paid the $9,000 invoice on January 11, 2011. What amount should Clark report as advertising expense in its income statement for the year ended December 31, 2010?

$122,000

$131,000

$140,000

$155,000

The balance in the advertising expense account on 12/31/10 before adjustment is $146,000. Since the sales promotional campaign is to be conducted in January, any associated costs are an expense of 2011. Thus, the $15,000 cost of printing catalogs should be removed from the advertising expense account and recorded as a prepaid expense as of 12/31/10. In addition, advertising expense must be increased by the $9,000 cost of December’s radio advertisements, which are an expense of 2010 even though they were not billed to Clark or paid until 2011. The $9,000 must be accrued as an expense and a liability at 12/31/10. Therefore, 2010 advertising expense should total $140,000 ($146,000 – $15,000 + $9,000).

Explanation

The balance in the advertising expense account on 12/31/10 before adjustment is $146,000. Since the sales promotional campaign is to be conducted in January, any associated costs are an expense of 2011. Thus, the $15,000 cost of printing catalogs should be removed from the advertising expense account and recorded as a prepaid expense as of 12/31/10. In addition, advertising expense must be increased by the $9,000 cost of December’s radio advertisements, which are an expense of 2010 even though they were not billed to Clark or paid until 2011. The $9,000 must be accrued as an expense and a liability at 12/31/10. Therefore, 2010 advertising expense should total $140,000 ($146,000 – $15,000 + $9,000).

4. Roro, Inc. paid $7,200 to renew its only insurance policy for three years on March 1, 2010, the effective date of the policy. At March 31, 2010, Roro's unadjusted trial balance showed a balance of $300 for prepaid insurance and $7,200 for insurance expense. What amounts should be reported for prepaid insurance and insurance expense in Roro's financial statements for the three months ended March 31, 2010? (Prepaid insurance; Insurance expense )

$7,000 $300

$7,000 $500

$7,200 $300

$7,300 $200

Apparently Roro records policy payments as charges to insurance expense and records prepaid insurance at the end of the quarter through an adjusting entry. The unadjusted trial balance amounts at 3/31/10 must represent the final two months of the old policy ($300 of prepaid insurance) and the cost of the new policy ($7,200 of insurance expense). An adjusting entry must be prepared to reflect the correct 3/31/10 balances. Since the new policy has been in force one month (3/1 through 3/31), thirty-five months remain unexpired. Therefore, the balance in prepaid insurance should be $7,000 ($7,200 × 35/36). Insurance expense should include the cost of the last two months of the old policy and the first month of the new policy [$300 + ($7,200 × 1/36) = $500]. Roro’s adjusting entry would transfer $6,700 from insurance expense to prepaid insurance to result in the correct balances.

Explanation

Apparently Roro records policy payments as charges to insurance expense and records prepaid insurance at the end of the quarter through an adjusting entry. The unadjusted trial balance amounts at 3/31/10 must represent the final two months of the old policy ($300 of prepaid insurance) and the cost of the new policy ($7,200 of insurance expense). An adjusting entry must be prepared to reflect the correct 3/31/10 balances. Since the new policy has been in force one month (3/1 through 3/31), thirty-five months remain unexpired. Therefore, the balance in prepaid insurance should be $7,000 ($7,200 × 35/36). Insurance expense should include the cost of the last two months of the old policy and the first month of the new policy [$300 + ($7,200 × 1/36) = $500]. Roro’s adjusting entry would transfer $6,700 from insurance expense to prepaid insurance to result in the correct balances.

5. Aneen's Video Mart sells one- and two-year mail order subscriptions for its video-of-the-month business. Subscriptions are collected in advance and credited to sales. An analysis of the recorded sales activity revealed the following: Subscriptions expirations: In Aneen's December 31, 2010 balance sheet, the balance for unearned subscription revenue should be

$495,000

$470,000

$465,000

$340,000

At 12/31/10, the liability account unearned subscription revenue should have a balance which reflects all unexpired subscriptions. Of the 2009 sales, $125,000 expires during 2011 and would still be a liability at 12/31/10. Of the 2010 sales, $340,000 ($200,000 + $140,000) expires during 2011 and 2012, and therefore is a liability at 12/31/10. Therefore, the total liability is $465,000 ($125,000 + $340,000). This amount would have to be removed from the sales account and recorded as a liability in a 12/31/10 adjusting entry.

Explanation

At 12/31/10, the liability account unearned subscription revenue should have a balance which reflects all unexpired subscriptions. Of the 2009 sales, $125,000 expires during 2011 and would still be a liability at 12/31/10. Of the 2010 sales, $340,000 ($200,000 + $140,000) expires during 2011 and 2012, and therefore is a liability at 12/31/10. Therefore, the total liability is $465,000 ($125,000 + $340,000). This amount would have to be removed from the sales account and recorded as a liability in a 12/31/10 adjusting entry.