How good is your understanding about accrual and deferral transaction? Take this quiz! This quiz post contains 15 problems in the accrual and deferral area of financial accounting and reporting. The questions are on the first section and the answer is on the next section in the same page.

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It is worth taking. Why? First, the problems are challenging, and the answers reveal most of the accrual and deferral theories and concept and those concepts are translated to answer real-transaction issues. Happy quiz taking! 🙂

 

Problem-1. Under a royalty agreement with another company, Lie Dharma Putra. will pay royalties for the assignment of a patent for three years. The royalties paid should be reported as expense:

a. In the period paid.
b. In the period incurred.
c. At the date the royalty agreement began.
d. At the date the royalty agreement expired.

Answer:
(b) 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).

 

Problem-2. Thomas Co.’s advertising expense account had a balance of $146,000 at December 31, 2012, 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 2013.
  • Radio advertisements broadcast during December 2012 were billed to Thomas on January 2, 2013. Thomas paid the $9,000 invoice on January 11, 2013.

What amount should Thomas report as advertising expense in its income statement for the year ended December 31, 2012?

a. $122,000
b. $131,000
c. $140,000
d. $155,000

Answer:
(c) The balance in the advertising expense account on 12/31/12 before adjustment is $146,000. Since the sales promotional campaign is to be conducted in January, any associated costs are an expense of 2013. Thus, the $15,000 cost of printing catalogs should be removed from the advertising expense account and recorded as a prepaid expense as of 12/31/12. In addition, advertising expense must be increased by the $9,000 cost of December’s radio advertisements, which are an expense of 2012 even though they were not billed to Thomas or paid until 2013. The $9,000 must be accrued as an expense and a liability at 12/31/12. Therefore, 2012 advertising expense should total $140,000 ($146,000 – $15,000 + $9,000).

 

Problem-3. An analysis of Thrift Corp.’s unadjusted prepaid expense account at December 31, 2012, 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, 2011.
  • A $3,200 annual insurance premium payment made July 1, 2012.
  • A $2,000 advance rental payment for a warehouse

Thrift leased for one year beginning January 1, 2013. In its December 31, 2012 balance sheet, what amount should Thrift report as prepaid expenses?

a. $5,200
b. $3,600
c. $2,000
d. $1,600

Answer:
(b) The opening balance in prepaid expenses ($1,500) results from a one-year insurance premium paid on 7/1/11. Since this policy would have expired by 6/30/12, no part of the $1,500 is included in 12/31/12 prepaid expenses. The insurance premium paid on 7/1/12 ($3,200) would be partially expired (6/12) by 12/31/12. The remainder (6/12 x $3,200 = $1,600) would be a prepaid expense at year-end. The entire advance rental payment ($2,000) is a prepaid expense at 12/31/12 because it applies to 2013. Therefore, total 12/31/12 prepaid expenses are $3,600.

Prepaid insurance ($3,200 x 6/12) $1,600
Prepaid rent                                   $2,000
Total prepaid expenses                  $3,600

 

Problem-4. Roro, Inc. paid $7,200 to renew its only insurance policy for three years on March 1, 2012, the effective date of the policy. At March 31, 2012, 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, 2012?

Prepaid insurance        Insurance expense:

a. $7,000                     $300
b. $7,000                     $500
c. $7,200                     $300
d. $7,300                     $200

Answer:
(b) 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 3/31/12 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 3/31/12 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 x 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 x 1/36) = $500]. Roro’s adjusting entry would transfer $6,700 from insurance expense to prepaid insurance to result in the correct balances.

 

Problem-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:

2011             2012
Sales                             $420,000      $500,000
Less cancellations        $   20,000 $  30,000
Net sales                       $400,000      $470,000

Subscriptions expirations:
2011                             $120,000
2012                             $155,000       $130,000
2013                             $125,000 $200,000
2014                                                   $140,000
$400,000        $470,000
In Aneen’s December 31, 2012 balance sheet, the balance for unearned subscription revenue should be

a. $495,000
b. $470,000
c. $465,000
d. $340,000

Answer:
(c) At 12/31/12, the liability account unearned subscription revenue should have a balance which reflects all unexpired subscriptions. Of the 2011 sales, $125,000 expires during 2013 and would still be a liability at 12/31/12. Of the 2012 sales, $340,000 ($200,000 + $140,000) expires during 2013 and 2014, and therefore is a liability at 12/31/12. 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 12/31/12 adjusting entry.

 

Problem-6. Regal Department Store sells gift certificates, redeemable for store merchandise, that expires one year after their issuance. Regal has the following information pertaining to its gift certificates sales and redemptions:

Unredeemed at 12/31/11                              $ 75,000
2012 sales                                                     $250,000
2012 redemptions of prior year sales           $25,000
2012 redemptions of current year sales        $175,000

Regal’s experience indicates that 10% of gift certificates sold will not be redeemed. In its December 31, 2012 balance sheet, what amount should Regal report as unearned revenue?

a. $125,000
b. $112,500
c. $100,000
d. $ 50,000

Answer:
(d) Regal’s unredeemed gift certificates at 12/31/11 are $75,000. During 2012, these certificates are either redeemed ($25,000) or expire by 12/31/12 ($75,000 – $25,000 = $50,000). Therefore, none of the $75,000 affects the 12/31/12 unearned revenue amount. During 2012, additional certificates totaling $250,000 were sold. Of this amount, $225,000 is expected to be redeemed in the future [$250,000 – (10% x $250,000)]. Since $175,000 of 2012 certificates were redeemed in 2012, 12/31/12 unearned revenue is
$50,000 ($225,000 – $175,000).

 

Problem-7. Wren Corp.’s trademark was licensed to Mont Co. for royalties of 15% of sales of the trademarked items. Royalties are payable semiannually on March 15 for sales in July through December of the prior year, and on September 15 for sales in January through June of the same year. Wren received the following royalties from Mont:

March 15       September 15
2011   $10,000         $15,000
2012   $12,000         $17,000

Mont estimated that sales of the trademarked items would total $60,000 for July through December 2012. In Wren’s 2012 income statement, the royalty revenue should be

a. $26,000
b. $29,000
c. $38,000
d. $41,000

Answer:
(a) The requirement is to calculate Wren’s royalty revenue for 2012. The 3/15/12 royalty receipt ($12,000) would not affect 2012 revenue because this amount pertains to revenues earned for July through December of 2011 and would have been accrued as revenue on 12/31/11. On 9/15/12, Wren received $17,000 in royalties for the first half of 2012. Royalties for the second half of 2012 will not be received until 3/15/13. However, the royalty payment to be received for the second six months (15% x $60,000 = $9,000) has been earned and should be accrued at 12/31/12. Therefore, 2012 royalty revenue is $26,000 ($17,000 + $9,000).\

 

Problem-8. In 2011, Super Comics Corp. sold a comic strip to Fantasy, Inc. and will receive royalties of 20% of future revenues associated with the comic strip. At December 31, 2012, Super reported royalties receivable of $75,000 from Fantasy. During 2013, Super received royalty payments of $200,000. Fantasy reported revenues of $1,500,000 in 2013 from the comic strip. In its 2013 income statement, what amount should Super report as royalty revenue?

a. $125,000
b. $175,000
c. $200,000
d. $300,000

Answer:
(d) The agreement states that Super is to receive royalties of 20% of revenues associated with the comic strip. Since Fantasy’s 2013 revenues from the strip were $1,500,000, Super’s royalty revenue is $300,000 ($1,500,000 x 20%). The other information in the problem about the receivable and cash payments is not needed to compute revenues. Super’s 2013 summary entries would be

[Debit]. Cash = 200,000
[Credit]. Royalties rec. = 75,000
[Credit]. Royalty revenue = 125,000 (=$200,000 – $75,000)

[Debit]. Royalties rec. = 175,000
[Debit]. Royalty revenue = 175,000 (=$300,000 – $125,000)

 

Problem-9. Rill Co. owns a 20% royalty interest in an oil well. Rill receives royalty payments on January 31 for the oil sold between the previous June 1 and November 30, and on July 31 for oil sold between December 1 and May 31. Production reports show the following oil sales:

June 1, 2011 – November 30, 2011             $300,000
December 1, 2011 – December 31, 2011    $  50,000
December 1, 2011 – May 31, 2012             $400,000
June 1, 2012 – November 30, 2012             $325,000
December 1, 2012 – December 31, 2012    $  70,000

What amount should Rill report as royalty revenue for 2012?

a. $140,000
b. $144,000
c. $149,000
d. $159,000

Answer:
(c) Royalty revenues should be recognized when earned, regardless of when the cash is collected. Royalty revenue earned from 12/1/11 to 5/31/12 is $80,000 ($400,000 x 20%). Of this amount, $10,000 ($50,000 x 20%) was earned in December of 2011, so the portion earned in the first five months of 2012 is $70,000 ($80,000 – $10,000). Royalty revenue earned from 6/1/12 to 11/30/12 is $65,000 ($325,000 x 20%). The amount earned from 12/1/12 to 12/31/12, which would be accrued at 12/31, is $14,000 ($70,000 x 20%). Therefore, 2012 royalty revenue is $149,000.

1/1/12 – 5/31/12       $ 70,000
6/1/12 – 11/30/12     $ 65,000
12/1/12 – 12/31/12   $ 14,000
$149,000

 

Problem-10. Decker Company assigns some of its patents to other enterprises under a variety of licensing agreements. In some instances advance royalties are received when the agreements are signed, and in others, royalties are remitted within sixty days after each license year-end. The following data are included in Decker’s December 31 balance sheet:

2011            2012
Royalties receivable   $90,000      $85,000
Unearned royalties     $60,000      $40,000

During 2012 Decker received royalty remittances of $200,000. In its income statement for the year ended December 31, 2012, Decker should report royalty income of

a. $195,000
b. $215,000
c. $220,000
d. $225,000

Answer:
(b) The requirement is to calculate the amount of royalty income to be recognized in 2012. Cash collected for royalties totaled $200,000 in 2012. However, this amount must be adjusted for changes in the related accounts, as follows:

2012 cash received                   $200,000
Royalties receivable 12/31/11    (90,000)
Royalties receivable 12/31/12      85,000
Unearned royalties 12/31/11        60,000
Unearned royalties 12/31/12      (40,000)
Royalty income                         $215,000

The beginning receivable balance ($90,000) is subtracted because that portion of the cash collected was recognized as revenue last year. The ending receivable balance ($85,000) is added because that amount is 2012 revenue, even though it has not yet been collected. The beginning balance of unearned royalties ($60,000) is added because that amount is assumed to be earned during the year. Finally, the ending balance of unearned royalties ($40,000) is subtracted since this amount was collected, but not earned as revenue, by
12/31/12.

 

Problem-11. Cooke Company acquires patent rights from other enterprises and pays advance royalties in some cases, and in others, royalties are paid within ninety days after year-end. The following data are included in Cooke’s December 31 balance sheets:

2011           2012
Prepaid royalties          $55,000      $45,000
Royalties payable        $80,000   $75,000

During 2012 Cooke remitted royalties of $300,000. In its income statement for the year ended December 31, 2012, Cooke should report royalty expense of

a. $295,000
b. $314,000
c. $310,000
d. $330,000

Answer:
(b) The requirement is to determine the amount of royalty expense to be recognized in 2012. Cash paid for royalties totaled $300,000 in 2012. However, this amount must be adjusted for changes in the related accounts, as follows:

2012 cash paid                     $300,000
Royalties payable 12/31/11  (80,000)
Royalties payable 12/31/12    75,000
Prepaid royalties 12/31/11      55,000
Prepaid royalties 12/31/12    (45,000)
$314,000

The beginning payable balance ($80,000) is subtracted because that portion of the cash paid was recognized as expense during the previous year. The ending payable balance ($75,000) is added because that amount has been accrued as 2012 expense, even though it has not yet been paid. The beginning balance of prepaid royalties ($55,000) is added because that amount is assumed to have expired during the year. Finally, the ending balance of prepaid royalties ($45,000) is subtracted since this amount was paid, but not incurred as an expense, by 12/31/12.

 

Problem-12. The premium on a three-year insurance policy expiring on December 31, 2014, was paid in total on January 1, 2012. The original payment was initially debited to a prepaid asset account. The appropriate journal entry has been recorded on December 31, 2012. The balance in the prepaid asset account on December 31, 2012, should be

a. Zero.
b. The same as it would have been if the original payment had been debited initially to an expense account.
c. The same as the original payment.
d. Higher than if the original payment had been debited initially to an expense account.

Answer:
(b) When the insurance policy was initially purchased, the entire balance was debited to a prepaid asset account (i.e., prepaid insurance). The adjusting entry at December 31, 2012, to recognize the expiration of one year of the policy would be

Insurance expense (1/3 of original pymt.)
Prepaid insurance (1/3 of original pymt.)

After the adjusting entry, the prepaid asset account would contain 2/3 of the original payment. If the original payment had instead been debited to an expense account (i.e., insurance expense), then the adjusting entry at December 31, 2012 would be

Prepaid insurance (2/3 of original pymt.)
Insurance expense (2/3 of original pymt.)

This alternate approach would also result in 1/3 of the original payment being expensed in 2012 and 2/3 of the original payment being carried forward as a prepaid asset. Thus, answer (b) is correct. Answer (a) is incorrect because the premium paid was for a three-year policy, 2/3 of which had not yet expired and would therefore be carried forward in the prepaid asset account. Answer (c) is incorrect because 1/3 of the original payment was already expensed. Answer (d) is incorrect because the amount would be the same as it would have been if the original payment had been debited initially to an expense account (as explained for answer (b) above).

 

Problem-13. On January 1, 2012, Sip Co. signed a five-year contract enabling it to use a patented manufacturing process beginning in 2012. A royalty is payable for each product produced, subject to a minimum annual fee. Any royalties in excess of the minimum will be paid annually. On the contract date, Sip prepaid a sum equal to two years’ minimum annual fees. In 2012, only minimum fees were incurred. The royalty prepayment should be reported in Sip’s December 31, 2012 financial statements as

a. An expense only.
b. A current asset and an expense.
c. A current asset and noncurrent asset.
d. A noncurrent asset.

Answer:
(b) Per ARB 43, chap 3A, current assets are identified as resources that are reasonably expected to be realized in cash or sold or consumed during the normal operating cycle of the business. These resources include prepaid expenses such as royalties. Since the balance remaining in Sip Co.’s royalty prepayment (the payment relating to 2013 royalties) will be consumed within the next year, it should be reported as a current asset. Additionally, the payment relating to 2012 should be reported as an expense.

 

Problem-14. A retail store received cash and issued gift certificates that are redeemable in merchandise. The gift certificates lapse one year after they are issued. How would the deferred revenue account be affected by each of the following transactions? Redemption of certificates Lapse of certificates

a. No effect Decrease
b. Decrease Decrease
c. Decrease No effect
d. No effect No effect

Answer:
(b) At the time the gift certificates were issued, the following entry was made, reflecting the store’s future obligation to honor the certificates:

[Debit]. Cash = xx
[Credit]. Deferred revenue = xx

Upon redemption of the certificates, the obligation recorded in the deferred revenue account becomes satisfied and the revenue is earned. Similarly, as the certificates expire, the store is no longer under any obligation to honor the certificates and the deferred revenue should be taken into income. In both instances, the deferred revenue account must be reduced (debited) to reflect the earning of revenue. This is done through the following entry:

[Debit]. Deferred revenue = xx
[Credit]. Revenue = xx

 

Problem-15. Jersey, Inc. is a retailer of home appliances and offers a service contract on each appliance sold. Jersey sells appliances on installment contracts, but all service contracts must be paid in full at the time of sale. Collections received for service contracts should be recorded as an increase in a:

a. Deferred revenue account.
b. Sales contracts receivable valuation account.
c. Stockholders’ valuation account.
d. Service revenue account.

Answer:
(a) The revenues from service contracts should be recognized on a pro rata basis over the term of the contract. This treatment allocates the contract revenues to the period(s) in which they are earned. Since the sale of a service contract does not culminate in the completion of the earnings process (i.e., does not represent the seller’s performance of the contract), payments received for such a contract should be recorded initially in a deferred revenue account.