Final answer:
The end-of-year adjusting entry for an agreement to provide consulting services would increase earned revenue and decrease deferred revenue. Based on a straight-line revenue recognition approach, 5/12 of the pre-collected fees would be recognized by December 31st of Year 1. The example of a firm's accounting profit is calculated by subtracting explicit costs from total revenues.
Step-by-step explanation:
The student's question relates to the treatment of revenue recognition for consulting services under accrual accounting principles. When the account received cash for services to be provided over a year, the cash collected would initially be recorded as deferred revenue, a liability. As the services are performed, the revenue is earned. Thus, at the end of the year, you would make an adjusting journal entry to recognize the portion of the revenue that has been earned.
For instance, if services are to be provided for 12 months beginning on August 1st of Year 1, and nothing else is known about the frequency or pattern of the services, then a straight-line approach would typically be used. By year-end, which is December 31st of Year 1, five months of services have been provided. Therefore, 5/12 of the annual fee would be recognized as earned revenue. The adjusting entry would increase revenues and decrease deferred revenues (a liability).
As a concrete example tied to a similar scenario, if a firm had sales revenue of $1 million last year and spent $600,000 on labor, $150,000 on capital, and $200,000 on materials, the firm's accounting profit equals total revenues minus explicit costs. Therefore, the profit would be computed as $1,000,000 - ($600,000 + $150,000 + $200,000) which gives an accounting profit of $50,000.