E2-7 (Accounting Principles—Comprehensive) Presented below are a number of business transactions that occurred during the current year for Fresh Horses, Inc.
Instructions
In each of the situations, discuss the appropriateness of the journal entries in terms of generally accepted accounting principles.
(a) The president of Fresh Horses, Inc. used his expense account to purchase a new Suburban solely for personal use. The following journal entry was made.
Miscellaneous Expense 29,000
Cash 29,000
(b) Merchandise inventory that cost $620,000 is reported on the balance sheet at $690,000, the expected selling price less estimated selling costs. The following entry was made to record this increase in value.
Merchandise Inventory 70,000
Revenue 70,000
(c) The company is being sued for $500,000 by a customer who claims damages for personal injury apparently caused by a defective product. Company attorneys feel extremely confident that the company will have no liability for damages resulting from the situation. Nevertheless, the company decides to make the following entry.
Loss from Lawsuit 500,000
Liability for Lawsuit 500,000
(d) Because the general level of prices increased during the current year, Fresh Horses, Inc. determined that there was a $16,000 understatement of depreciation expense on its equipment and decided to record it in its accounts. The following entry was made.
Depreciation Expense 16,000
Accumulated Depreciation 16,000
(e) Fresh Horses, Inc. has been concerned about whether intangible assets could generate cash in case of liquidation. As a consequence, goodwill arising from a purchase transaction during the current year and recorded at $800,000 was written off as follows.
Retained Earnings 800,000
Goodwill 800,000
(f)
Because of a “fire sale,” equipment obviously worth $200,000 was acquired at a cost of
$155,000.
The following entry was made.
Equipment 200,000
Cash 155,000
Revenue 45,000

(a) This entry violates the economic entity assumption. This assumption in accounting indicates that economic activity can be identified with a particular unit of accountability. In this situation, the company erred by charging this cost to the wrong economic entity.
(b) The historical cost principle indicates that assets and liabilities are accounted for on the basis of cost. If we were to select sales value, for example, we would have an extremely difficult time in attempting to establish a sales value for a given item without selling it. It should further be noted that the revenue recognition principle provides the answer to when revenue should be recognized. Revenue should be recognized when (1) realized or realizable and (2) earned. In this situation, an earnings process has definitely not taken place.
(c) Probably the company is too conservative in its accounting for this transaction. The matching principle indicates that expenses should be allocated to the appropriate periods involved. In this case, there appears to be a high uncertainty that the company will have to pay. FASB Statement No. 5 requires that a loss should be accrued only (1) when it is probable that the company would lose the suit and
(2) the amount of the loss can be reasonably estimated. (Note to instructor: The student will probably be unfamiliar with FASB Statement No. 5. The purpose of this question is to develop some decision framework when the probability of a future event must be assumed.)
(d) At the present time, accountants do not recognize price-level adjust-ments in the accounts. Hence, it is misleading to deviate from the cost principle because conjecture or opinion can take place. It should also be noted that depreciation is not so much a matter of valuation as it is a means of cost allocation. Assets are not depreciated on the basis of a decline in their fair market value, but are depreciated on the basis of systematic charges of expired costs against revenues. (Note to instructor:
It might be called to the students’ attention that the FASB does encourage supplemental disclosure of price-level information.)
(e) Most accounting methods are based on the assumption that the busi-ness enterprise will have a long life. Acceptance of this assumption provides credibility to the historical cost principle, which would be of limited usefulness if liquidation were assumed. Only if we assume some permanence to the enterprise is the use of depreciation and amortization policies justifiable and appropriate. Therefore, it is

incor-rect to assume liquidation as Fresh Horses, Inc. has done in this situation. It should be noted that only where liquidation appears imminent is the going concern assumption inapplicable.
(f) The answer to this situation is the same as (b).
E3-5 (Adjusting Entries) The ledger of Duggan Rental Agency on March 31 of the current year includes the following selected accounts before adjusting entries have been prepared.
Debit Credit
Prepaid Insurance $ 3,600
Supplies 2,800
Equipment 25,000
Accumulated Depreciation—Equipment $ 8,400
Notes Payable 20,000
Unearned Rent Revenue 9,300
Rent Revenue 60,000
Interest Expense –0–
Wage Expense 14,000
An analysis of the accounts shows the following.
1. The equipment depreciates $250 per month.
2. One-third of the unearned rent was earned during the quarter.
3. Interest of $500 is accrued on the notes payable.
4. Supplies on hand total $850.
5. Insurance expires at the rate of $300 per month.
Instructions
Prepare the adjusting entries at March 31, assuming that adjusting entries are made quarterly.
Additional accounts are: Depreciation Expense; Insurance Expense; Interest Payable; and Supplies Expense.
(Omit explanations.)
WATTEAU CO.
TRIAL BALANCE
JUNE 30, 2007
Debit Credit
Cash $ 2,870
Accounts Receivable $ 3,231
Supplies 800
Equipment 3,800
Accounts Payable 2,666
Unearned Service Revenue 1,200

Common Stock 6,000
Retained Earnings 3,000
Service Revenue 2,380
Wages Expense 3,400
Office Expense 940
$13,371 $16,916
(L0 5)
1. Depreciation Expense ..........................................................................................................
Accumulated Depreciation – Equipment ................................................................. 750
2. Unearned Rent Revenue .....................................................................................................
Rent Revenue.............................................................................................................. 3,100
3. Interest Expense ..................................................................................................................
Interest Payable.......................................................................................................... 500
4. Supplies Expense .................................................................................................................
Supplies ....................................................................................................................... 1,950
5. Insurance Expense ...............................................................................................................
Prepaid Insurance ...................................................................................................... 900

Instructions
(a) Construct T-accounts and enter the balances shown.
(b) Prepare adjusting journal entries for the following and post to the T-accounts. (Omit explanations.)
Open additional T-accounts as necessary. (The books are closed yearly on December 31.)
(1) Bad debts are estimated to be $1,400.
(2) Furniture and equipment is depreciated based on a 6-year life (no salvage value).
(3) Insurance expired during the year $2,550.
(4) Interest accrued on notes payable $3,360.
(5) Sales salaries earned but not paid $2,400.
(6) Advertising paid in advance $700.
(7) Office supplies on hand $1,500, charged to Office Expense when purchased.
(c) Prepare closing entries and post to the accounts.
(a), (b), (c)
Cash
Bal. 18,500
Accounts Receivable
Bal. 42,000
Allow. for Doubtful Accts.
Bal.
Adj.
700
1,400

Inventory
Bal. 80,000
Prepaid Insurance
Furniture & Equipment
Bal. 84,000
Notes Payable
Accum. Depr. of F. & E.
Bal. 35,000
Adj. 14,000
Admin. Salaries Expense
Bal. 5,100 Adj. 2,550 Bal. 28,000 Bal. 65,000 Cls. 65,000
Common Stock Sales Insurance Expense
Bal. 80,600 Cls. 600,000 Bal. 600,000 Adj. 2,550 Cls. 2,550
Sales Salaries Expense Advertising Expense Interest Expense
Bal. 50,000 Cls. 52,400 Bal.
Adj. 2,400
6,700 Adj. 700 Adj.
Close 6,000
3,360 Close 3,360
52,400 52,400 6,700 6,700
Bad Debt Expense Office Expense Prepaid Advertising Expense
Adj. 1,400 Cls. 1,400 Bal. 5,000 Adj. 1,500 Adj.
Close 3,500
5,000 5,000
Interest Payable Depr. Exp.—Furn. & Equip.
700
Income Summary
Adj. 3,360 Adj. 14,000 Cls. 14,000 Exp. 546,210 Sales 600,000
Inc. 53,790
600,000 600,000

Office Supplies
Adj. 1,500
Retained Earnings
Salaries Payable
Adj.
Cost of Goods Sold
2,400
Bal. 10,000 Bal. 398,000 Cls. 398,000
Inc. 53,790
Bal. 63,790
(b) -1-
Allowance for Doubtful Accounts ............................................................................
-2-
Depreciation Expense—Furniture and
1,400
Accum. Depr.—Furniture and Equipment .............................................................
-3-
14,000
Prepaid Insurance ..................................................................................................... 2,550

-4-
3,360 Interest Payable .........................................................................................................
-5-
2,400 Salaries Payable .........................................................................................................
-6-
700 Advertising Expense ..................................................................................................
-7-
Office Expense ........................................................................................................... 1,500
(c)
Sales
Dec. 31
600,000
Income Summary ....................................................................................................... 600,000

Dec. 31
Cost of Goods Sold ..................................................................................................... 398,000
Advertising Expense ..................................................................................................
Administrative Salaries Expense ..............................................................................
Sales Salaries Expense ...............................................................................................
Office Expense ...........................................................................................................
Insurance Expense .....................................................................................................
Bad Debt Expense ......................................................................................................
6,000
65,000
52,400
3,500
2,550
1,400
Depreciation Expense—Furniture and
Equipment ..............................................................................................................
Interest Expense .........................................................................................................
Dec. 31
14,000
3,360
Retained Earnings ..................................................................................................... 53,790

Instructions
(a) For each plant:
(2) Compute equivalent units of production for materials and for conversion costs.
(b) Prepare the production cost report for Plant A for June 2005.
(a) (1) Physical units
Units to be accounted for
Work in process, June 1
Started into production
Total units
Units accounted for
Transferred out
Work in process, June 30
Total units
(2) Equivalent units
R12
Refrigerators
0
20,000
20,000
18,000
2,000
20,000
F24
Freezers
0
20,000
20,000
17,000
3,000
20,000
R12 Refrigerators
Conversion

Units transferred out
Work in process, June 30
(2,000 X 100%)
(2,000 X 70%)
Total equivalent units
Materials
18,000
2,000
00,000
20,000
Costs
18,000
1,400
19,400
Units transferred out
Work in process, June 30
(3,000 X 100%)
(3,000 X 50%)
Total equivalent units
(3) Unit costs
Materials ($840,000 ÷ 20,000)
($700,000 ÷ 20,000)
Conversion costs
($620,800* ÷ 19,400)
($555,000** ÷ 18,500)
Total
Materials
17,000
F24 Freezers
Conversion
Costs
17,000
3,000
00,000
20,000
1,500
18,500
Plant A
R12
Refrigerators
$42
32
000
$74
Plant B
F24
Freezers
$35
30
$65
*$200,800 + $420,000
**$236,000 + $319,000
(4)
Plant A
R12 Refrigerators
Costs accounted for
Transferred out (18,000 X $74)
Work in process
Materials (2,000 X $42)
Conversion costs
(1,400 X $32.00)
Total costs
$84,000
44,800
$1,332,000
128,800
$1,460,800

Costs accounted for
Plant B
F24 Freezers
Transferred out (17,000 X $65)
Work in process
Materials (3,000 X $35)
Conversion costs
(1,500 X $30)
Total costs
STEIN CORPORATION (b)
Quantities
Units to be accounted for
Work in process, June 1
Started into production
Total units
Units accounted for
Transferred out
Work in process, June 30
Stamping Department—Plant A
Production Cost Report
Physical
Units
(Step 1)
0
20,000
$105,000
45,000
For the Month Ended June 30, 2007
Equivalent Units
Conversion
Materials
(Step 2)
Costs
20,000
18,000 18,000
2,000 2,000
18,000
1,400
20,000 20,000 19,400 Total units
Costs
Unit costs (Step 3)
Costs in June
Equivalent units
Unit costs [(a) ÷ (b)]
Costs to be accounted for
Work in process, June 1
Started into production
Total costs
Cost Reconciliation Schedule (Step 4)
(a)
(b)
Materials
$840,000
20,000
$42
Conversion
Costs
$620,800
19,400
$32
$1,105,000
150,000
$1,255,000
(2,000 X
70%)
Total
$1,460,800
$74
$ 0
1,460,800
$1,460,800

Costs accounted for
Transferred out (18,000 X $74)
Work in process, June 30
Materials (2,000 X $42)
Conversion costs (1,400 X $32)
Total costs
$84,000
44,800
$1,332,000
128,800
$1,460,800