Question

Question: The Amato Theater is nearing the end of the year and is preparing for a meeting with its bankers to discuss the renewal of a loan. The accounts listed below appeared in the December 31, 2017, trial balance.

	Debit	Credit
Prepaid advertising	\(6,000
Equipment	192,000
Accumulated depreciation		\)60,000
Note payable		90,000
Unearned service revenue		17,500
Ticket revenue		360,000
Advertising expenses	18,680
Salaries and wages expenses	67,600
Interest expenses	1,400

Additional information is available as follows.

1. The equipment has an estimated useful life of 16 years and a salvage value of \(40,000 at the end of that time. Amato uses the straight-line method for depreciation.

2. The note payable is a one-year note given to the bank January 31 and bearing interest at 10%. Interest is calculated on a monthly basis.

3. Late in December 2017, the theater sold 350 coupon ticket books at \)50 each. Two hundred of these ticket books have been used by year-end. The cash received was recorded as Unearned Service Revenue.

4. Advertising paid in advance was \(6,000 and was debited to Prepaid Advertising. The company has used \)2,500 of the advertising as of December 31, 2017.

5. Salaries and wages accrued but unpaid at December 31, 2017, were $3,500.

Accounting

Prepare any adjusting journal entries necessary for the year ended December 31, 2017.

Analysis

Determine Amato’s income before and after recording the adjusting entries. Use your analysis to explain why Amato’s bankers should be willing to wait for Amato to complete its year-end adjustment process before making a decision on the loan renewal.

Principles

Although Amato’s bankers are willing to wait for the adjustment process to be completed before they receive financial information, they would like to receive financial reports more frequently than annually or even quarterly. What trade-offs, in terms of relevance and faithful representation, are inherent in preparing financial statements for shorter accounting time periods?

Short answer

Answer

1. Both sides of the journal total$33,750.
2. The net income of the business entity is overstated when adjusting entries are not made.
3. Reporting financial information frequently to users will increase the relevance of the financial statements.

Step-by-step solution

Definition of Adjusting Entries

Adjusting entries can be defined as those made at year-end to adjust and update the balance of some of the general ledger accounts. These entries are done when the business entity uses the accrual basis of accounting.

Adjusting Journal Entries

Date	Accounts and Explanation	Debit ($)	Credit ($)
31 Dec 2017	Depreciation expenses	9,500
	Accumulated depreciation – Equipment		9,500
31 Dec 2017	Interest expenses	8,250
	Interest payable		8,250
	$\left(\$90,000\times 10\%\times \frac{11}{12}\right)$
31 Dec 2017	Unearned service revenue	10,000
	Service revenue $\left(200\times \$50\right)$		10,000
31 Dec 2017	Advertising expenses	2,500
	Prepaid advertising		2,500
31 Dec 2017	Salaries and wages expenses	3,500
	Salaries and wages payable		3,500
		$33,750	$33,750

Working note:

1. Calculation of depreciation expenses for equipment

$$\begin{gathered} \mathit{D}\mathit{e}\mathit{p}\mathit{r}\mathit{e}\mathit{c}\mathit{i}\mathit{a}\mathit{t}\mathit{i}\mathit{o}\mathit{n}\mathbf{}\mathit{e}\mathit{x}\mathit{p}\mathit{e}\mathit{n}\mathit{s}\mathit{e}\mathit{s}\mathbf{=}\frac{\mathbf{C}\mathbf{o}\mathbf{s}\mathbf{t}\mathbf{-}\mathbf{S}\mathbf{a}\mathbf{l}\mathbf{v}\mathbf{a}\mathbf{g}\mathbf{e}\mathbf{v}\mathbf{a}\mathbf{l}\mathbf{u}\mathbf{e}}{\mathbf{U}\mathbf{s}\mathbf{e}\mathbf{f}\mathbf{u}\mathbf{l}\mathbf{l}\mathbf{i}\mathbf{f}\mathbf{e}} \\ \mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{=}\frac{\mathbf{\$}\mathbf{192}\mathbf{,}\mathbf{000}\mathbf{-}\mathbf{\$}\mathbf{40}\mathbf{,}\mathbf{000}}{\mathbf{16}} \\ \mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{=}\mathbf{\$}\mathbf{9}\mathbf{,}\mathbf{500} \end{gathered}$$

Income before and after recording adjusting entries

Particular	Income before adjustments	Adjustments	Income after adjustments
Service revenue	$360,000	$10,000	$370,000
Less:
Depreciation expenses		(9,500)	(9,500)
Advertising expenses	(18,680)	(2,500)	(21,180)
Salaries and wages expenses	(67,600)	(3,500)	(71,100)
Interest expenses	(1,400)	(8,250)	(9,650)
Net income	$272,320		$258,570

The loan is provided based on the liquidity position of the business entity. The adjusting entries would correct the misstated balance of the current assets and liabilities. Therefore, the bankers should wait for year-end adjustments.

Principles

The trade-offs between the time the business entity prepares the reports. Timeliness of the reporting contributed to the relevancy and verifiability of the financial statements.

If the business entity prepares reports frequently, the users will get information on time, which will help them make decisions.

At the same time, frequent preparation of the reports will require more estimates that will reduce the faithfulness of the reports.