Exercise 3-48 (Algorithmic) Expense Adjustments Faraday Electronic Service repairs stereos and DVD players. During 2019, Faraday engaged in the following activities: On September 1, Faraday paid Wausau Insurance $4,560 for its liability insurance for the next 12 months. The full amount of the prepayment was debited to prepaid insurance. At December 31, Faraday estimates that $1,620 of utility costs are unrecorded and unpaid. Faraday rents its testing equipment from JVC. Equipment rent in the amount of $3,430 is unpaid and unrecorded at December 31. In late October, Faraday agreed to become the sponsor for the sports segment of the evening news program on a local television station. The station billed Faraday $4,500 for 3 months' sponsorship—November 2019, December 2019, and January 2020—in advance. When these payments were made, Faraday debited prepaid advertising. At December 31, 2 months' advertising has been used and 1 month remains unused. Required: 1. Prepare adjusting entries at December 31 for these four activities. Dec. 31 (Record use of prepaid insurance) Dec. 31 (Record use of utilities) Dec. 31 (Record use of equipment) Dec. 31 (Record use of prepaid advertising) 2. Conceptual Connection: What would be the effect on expenses if the adjusting entries were not made? a. b. c. d. Cumulative effect on expenses: by $
1. Adjusting entries at December 31:
Dec. 31 (Record use of prepaid insurance):
Insurance Expense $3,120
Prepaid Insurance $3,120
Dec. 31 (Record use of utilities):
Utility Expense $1,620
Accounts Payable $1,620
Dec. 31 (Record use of equipment):
Equipment Rent Expense $3,430
Accounts Payable $3,430
Dec. 31 (Record use of prepaid advertising):
Advertising Expense $3,000
Prepaid Advertising $3,000
2. Conceptual Connection: If the adjusting entries were not made, the expenses would be understated. The prepaid insurance, utility costs, equipment rent, and prepaid advertising would not be recognized as expenses in the current period, resulting in an inaccurate representation of the company's financial performance and profitability.
1. Prepare adjusting entries at December 31 for these four activities:
Dec. 31 (Record use of prepaid insurance):
Debit: Insurance Expense $1,620
Credit: Prepaid Insurance $1,620
Dec. 31 (Record use of utilities):
Debit: Utilities Expense $1,620
Credit: Accounts Payable $1,620
Dec. 31 (Record use of equipment):
Debit: Equipment Rent Expense $3,430
Credit: Accounts Payable $3,430
Dec. 31 (Record use of prepaid advertising):
Debit: Advertising Expense $3,000 (2 months x $1,500 per month)
Credit: Prepaid Advertising $3,000
2. Conceptual Connection: What would be the effect on expenses if the adjusting entries were not made?
a. Insurance Expense would be understated by $1,620, as the unrecorded and unpaid utility costs were not recognized.
b. Utilities Expense would be understated by $1,620, as the unrecorded and unpaid utility costs were not recognized.
c. Equipment Rent Expense would be understated by $3,430, as the unpaid and unrecorded equipment rent was not recognized.
d. Advertising Expense would be overstated by $1,500, as the unused month of prepaid advertising was not recognized.
Cumulative effect on expenses: $1,620 (understated insurance expense) + $1,620 (understated utilities expense) + $3,430 (understated equipment rent expense) - $1,500 (overstated advertising expense) = $5,170 (understated expenses)
To prepare the adjusting entries for the four activities mentioned, we need to determine the adjustments for each of them.
1. Prepaid Insurance:
The adjusting entry is needed to record the portion of prepaid insurance that has expired as an expense. The adjustment is calculated as the difference between the total prepaid insurance paid at the beginning ($4,560) and the portion that remains as of December 31 ($1,620).
Adjusting entry: Dec. 31
Insurance Expense $2,940
Prepaid Insurance $2,940
2. Utilities Expense:
The adjusting entry is required to recognize the utility costs that are unrecorded and unpaid as of December 31 ($1,620) as an expense.
Adjusting entry: Dec. 31
Utilities Expense $1,620
Accrued Utilities Payable $1,620
3. Equipment Rent:
The adjusting entry is necessary to record the unpaid and unrecorded equipment rent as an expense.
Adjusting entry: Dec. 31
Rent Expense $3,430
Accrued Equipment Rent $3,430
4. Prepaid Advertising:
The adjusting entry is needed to recognize the portion of prepaid advertising that has been used (2 months) and the unused portion (1 month) as an expense.
Adjusting entry: Dec. 31
Advertising Expense $3,000
Prepaid Advertising $3,000
Now let's address the second question:
2. Conceptual Connection: What would be the effect on expenses if the adjusting entries were not made?
a. The expense for insurance would be understated since the expired portion of the prepaid insurance would not be recognized.
b. The expense for utilities would be understated since the unrecorded and unpaid portion of utility costs would not be recognized.
c. The expense for equipment rent would be understated since the unpaid and unrecorded portion of rent would not be recognized.
d. The expense for prepaid advertising would be overstated since the portion of advertising that has been used would not be recognized, and the unused portion would still be considered as an expense.
Cumulative effect on expenses: The cumulative effect on expenses would be an understatement of $2,940 (prepaid insurance) + $1,620 (utilities) + $3,430 (equipment rent) - $3,000 (prepaid advertising) = $4,990. This means that if the adjusting entries were not made, the expenses on the income statement would be $4,990 lower than they should be.